Your IndustryJan 22 2015

Pros and cons of a bypass trust

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Under current rules, a pension death lump sum is charged at 55 per cent if the fund was already crystallised and in payment, or if the deceased was over the age of 75. The same rate of tax is also payable on any amount over the current lifetime allowance of £1.25m.

Otherwise, these ‘discretionary’ payments - they are so termed because the provider can refuse to pay out in certain circumstances - is paid to the nominated beneficiary free of inheritance tax.

However on the death of the beneficiary, any remaining lump sum would then be included in their estate, adding to the beneficiary’s own potential inheritance tax bill.

A bypass trust is an irrevocable discretionary trust which is set up separately from the pension plan.

By nominating the bypass trust as the recipient of the death benefits instead of the beneficiary themselves, the trustees can make payments to the beneficiary without it forming part of the beneficiary’s estate for inheritance tax purposes.

If the spouse desires funds from a bypass trust, Danny Cox, head of financial planning at Bristol-based Hargreaves Lansdown, says monies can either be paid to the spouse or loaned, the latter of which will avoid increasing the value of the spouse’s taxable estate.

Where a pension scheme offers lump sum death benefits, if these benefits are normally free of inheritance tax (IHT), then Mr Cox says they will generally also be free of IHT when paid to a trust.

Mr Cox says: “A ‘bypass’ trust may be used to minimise IHT on second death by keeping any death benefits outside of the surviving spouse’s estate while still allowing them potential access to the funds.

“Using a spousal bypass trust is second death planning and does not save immediate inheritance tax. Therefore the suitability of this type of trust (effectively just a discretionary trust) depends on the likely significance and urgency of estate planning.

“A spousal bypass trust provides the potential for inheritance tax savings of up to 40 per cent of the value of pension funds, while leaving the option for the surviving spouse to benefit from the funds if required.”

A bypass trust is drafted so as to grant wide powers to the trustees, says Tracyann Kneen, tax and trusts technical manager at James Hay Partnership.

Ms Kneen says the wide class of trust beneficiaries enables several generations of family members to benefit. As well as being able to make outright payments of trust monies to beneficiaries, Ms Kneen says the trustees can make loans to beneficiaries.

She says this may create a debt on the beneficiary’s estate assuming the loan is still outstanding on their death, thus reducing the value of their inherited estate.

Ms Kneen says: “The member may feel that the trustees of a bypass trust will know their wishes as to how and to whom the death benefits should be applied better than a scheme administrator.”

According to Ms Kneen other benefits of a bypass trust include:

1) The value of the trust fund is not assessable for state benefit purposes including long term care.

2) Potentially greater protection in terms of safeguarding capital for the member’s intended beneficiaries in the event of the death, divorce or bankruptcy of the intended beneficiary.

While these advantages are especially pertinent to the member, Ms Kneen says there is also an opportunity for the financial adviser to offer investment advice to the trustees and beneficiaries who receive these benefits.

The flip side

In terms of the downside, Ms Kneen says the payment of the death benefits to the trustees still relies on the discretion of the pension administrator, meaning it remains subject to their right to refuse payment in certain circumstances

However she points out the scheme administrator will carefully heed the wishes of the member.

Ms Kneen adds a ‘carve out’ trust is not generally advisable in cases where the member is in poor health, as the assignment of the death benefits may have a significant value for inheritance tax potentially resulting in a tax charge on the member if they were to die within two years.

She says the member must fully understand the implications of setting up a bypass trust to ensure that it is fit for purpose given their personal and family circumstances and that ultimately it meets the member’s objectives.

Ms Kneen says: “This is especially true given that these trusts are usually written on an irrevocable basis.”

While a bypass trust is a very flexible way for a spouse to have access to income as and when they need it, Claire Trott, head of technical support at Talbot & Muir, points out it will however be subject to periodic charges every 10 years.

When this 10-year period starts will depend on the way in which the trust is established and where the funds are paid from on death. If they come from a trust based pension scheme then Ms Trott says the period is calculated from the date the original pension scheme is joined.

If it isn’t a trust-based pension scheme, then Ms Trott says it is calculated from the date the funds are paid into the trust.

Paul Evans, pension technical manager of Suffolk Life, adds that bypass trusts are likely to form part of a client’s wider succession planning and it is recommended that legal advice is taken when arranging bypass trusts in order to ensure that they fit into a client’s overall plans.

He says this can make the trust expensive to establish.

Additionally, Mr Evans says the trust will need to be reviewed periodically to ensure it reflects the clients’ circumstances and preferences, resulting in additional costs.

He adds: “The client will need to be in good health at the time the trust is established.

“If the client is in poor health and dies within two years of establishing the trust, any benefits paid into the trust could be classified as a chargeable lifetime transfer for IHT purposes, making the fund liable for IHT.”