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Pros and cons of a bypass trust

This article is part of
Guide to Bypass Trusts and Pension Freedoms

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.