A "bypass trust" is a trust set up to receive a lump sum death benefit from a pension following the death of a member. In the past, they were commonly used to pass lump sum payments to a trust rather than to the pension member's surviving spouse to prevent the funds being included in the surviving spouse's estate on their subsequent death, therefore avoiding inheritance tax.
Following the substantial changes to pension rules in 2015 and the introduction of flexibility to pass pensions down the generations, they are less common. In this article, we consider the circumstances in which a pension bypass trust might remain appropriate.
The purpose of a bypass trust
A client might wish to use a bypass trust to take control of the pension funds away from the pension scheme trustees and pass that control to their own selected trustees. The trustees of the bypass trust will have discretion as to the ultimate recipients and timing of benefits.
Bypass trusts can be particularly useful where there is a second marriage and children from previous relationships. The pension scheme member can ask the trustees of the bypass trust to provide for their surviving spouse during the remainder of their spouse's lifetime but following the spouse's subsequent death the remaining fund can be passed down to the member's own children.
If instead the surviving spouse received a lump sum or inherited a drawdown pension, the member would not be able to control the ultimate beneficiaries of the funds following their surviving spouse's subsequent death. The surviving spouse could complete their own expression of wish form to nominate their own children as beneficiaries of death benefits from a pension they had inherited from their spouse. If they had inherited a lump sum payment directly, the cash could be left to their own family under their will.
Trusts are also useful for single parents with young children who can leave lump sum payments to such vulnerable beneficiaries in trust allowing the trustees to use the trust funds for appropriate purposes but delaying the inheritance to a more appropriate age of, say 25 or 30.
Disadvantages of bypass trusts
The control which can be achieved by a trust comes with some disadvantages. There are costs in establishing trusts and in complying with ongoing administration and tax. If the pension scheme member dies after the age of 75 then there is a 45% trust entry tax charge. For the majority of scheme members, they may prefer to name their spouse and children, including adult children, as potential beneficiaries of an inherited "beneficiary drawdown" pension.
If the member dies before age 75, then the pension lump sum benefit is paid to the trust tax free. However, income tax and capital gains tax will arise on the investments within the trust and there may also be inheritance tax payments due from time to time. Clients may prefer to leave their pension funds to their chosen beneficiaries within a pension wrapper where these tax charges do not apply.
Summary
This series of articles highlights the importance of reviewing pension death benefits. We recommend clients to take independent financial advice about their pensions, including pension death benefits. The first article in this series was a general introduction to reviewing pension death benefits and the second article looked at expression of wish forms.
For further information on any of the legal issues raised in this series, please get in touch.
Contributor
Partner
