Pension Death Benefit or Bypass Trusts (sometimes called ‘Spousal Bypass Trusts’ or ‘Pilot Trusts’) have been popular for some years.
The basic idea is that your pension death benefits are nominated on your death to a separate trust set up during your lifetime, specifically to receive them. These trusts tend to be discretionary (flexible) trusts, often set up with £10 or less.
If you have more than one pension (and over a career it is easy to accumulate a few different pensions), as each pension is generally a separate trust in its own right, it is possible to create pilot trusts for each pension fund and so secure multiple inheritance tax free ‘nil rates bands’ (NRB). Each trust has its own NRB, which on current figures is £325,000 and so funds in each trust, up to this amount should not suffer any inheritance tax going forward. Your pension death benefits in these trusts can be used to benefit your surviving spouse and your children and others. Because the funds are held in separate trusts, they do not form part of any beneficiaries own estate for inheritance tax purposes.
If on the other hand your pension death benefits are just nominated outright to your spouse, there is no inheritance tax when you die because of a special spouse exemption from inheritance tax. The problem arises if the funds remain as ‘cash’, or assets in your spouse’s hands as there is no protection from inheritance tax when they subsequently die and normal inheritance tax limits apply, so that anything over your spouse’s inheritance tax free amount passing say to your children, will suffer 40% inheritance tax.
Instead if the pension benefits are paid to a Pension Bypass Trust, both your spouse and children can benefit, but the funds are not aggregated with their estate when they die for inheritance tax purposes. It is a way for them to ‘have their cake and eat it’. The ongoing Pension Bypass Trust may also be useful if your children’s own financial or personal circumstances become precarious for any reason.
With the correct people as trustees the arrangements potentially offer your family and beneficiaries tax efficiency, with ongoing fund protection, and flexibility.
Pension Changes and New Pension Flexibility
New pension rules were introduced in April 2015 and they change the way pensions can pass on death. The new rules apply to any payments made from pensions after this date and offer lots of new opportunities to families.
Given these new rules people are asking whether there is any benefit now in creating a Pension Bypass Trust. The opinion of professional advisers is divided. Advice will depend on your circumstances and the circumstances of your family.
Under the new rules, if you die before age 75, regardless of whether you are drawing funds from your pension, your entire pension funds can be passed on tax free to your nominated beneficiary. Your beneficiary can take funds as a lump sum, or opt for the new ‘flexi access drawdown’ system. No one is now compelled to take an annuity and instead the pension income can be enjoyed in a more flexible way. Your named beneficiary does not have to be a dependant and so there is greatly increased flexibility about how to pass your pension on. The funds stay invested within the protective pension wrapper.
These options really improve the pension planning landscape and are intended to encourage us all to save into our pensions. Pension investment are now much more appealing to many people. The potential problem after you die however and where the funds stay in the pension rather than a Pension Bypass Trust, is that control and choice then lies entirely in the hands of your beneficiaries. This is why you may still chose to create a Pension Bypass Trust(s). Then control and management rests with your chosen trustees and so for example, younger generation beneficiaries cannot simply choose to spend all of the capital, perhaps unwisely!
Before the pension rules changed, once you started to draw your pension, or if you were 75, it was unattractive to pass on your pension as a lump sum. Under the old rules, your beneficiary would have been taxed at the rate of 55%. Now the options are much more flexible and appealing. For payments made from 6th April 2016 onwards the pension is taxed at the beneficiary’s highest marginal income tax rate.
Now your pension can be seen as a way of providing a flexible income firstly for your spouse and then, or at your spouse’s request, for the younger generation. As your pensions funds are passed down between beneficiaries, tax will be determined by the age of the beneficiary when they die, rather than your age as the original pension member. If your beneficiary dies before age 75, their successor beneficiary can receive a tax free lump sum, or continue with tax free draw down. If your beneficiary dies over age 75 then their successor beneficiary can take a taxable draw down and pay tax at their marginal rate of income tax.
Pensions can now provide a tax efficient wrapper, in theory allowing funds to pass down through the generations without the funds ever becoming part of anyone’s estate for inheritance tax purposes. There is the possibility of providing tax free income to children and grandchildren. The larger your pension fund is, the more likely it is to support multiple generations. More modest funds are unlikely to be able to provide long term funding for a family.
An inherited pension does not count towards your beneficiary’s lifetime pension allowance, so they can have their own pension in addition to their inherited pension, all enjoying tax benefits.
If your beneficiary or their successor want to take a lump sum from the pension fund, it must be paid before the second anniversary of the death of either the beneficiary, or the successor. There is no requirement to take pension draw down within this two year period, a designation that the pension is going to be held in draw down is all that should be needed.
Because invested pension funds have a number advantageous tax reliefs – in relation to income tax, inheritance tax and capital gains tax, some advisors think that Pension Bypass Trusts are now unattractive in comparison. The new rules allow others to benefit from pension funds and keeping the funds outside their own estate for inheritance tax purposes. Traditionally this was the key selling point of the Pension Bypass Trust.
With a Pension Bypass Trust, trustees will pay income tax at 45% and capital gains tax at 20%. Distributions may counter balance these rates if the beneficiaries are able to reclaim the tax. If the trust receives more than the NRB then there is also the possibility of ten yearly and exit inheritance tax charges (up to 6% on the excess above the NRB).
Pension Bypass Trusts however continue to offer protection in relation to matters other than tax. You may not want to give your children the very wide flexibility that the current pension rules offer. Do you want your children to be able to access all the capital as a lump sum and spend it? Tax is not the only driver. If protecting your funds and your beneficiaries is important then you will still want to create a Pension Bypass Trust.
Multiple Pilot Trusts to secure multiple NRBs might not secure any tax advantage, it depends. The Second Finance Act of 2015 introduced new rules in cases where assets are added to two or more trusts on the same day. The rules require the values to be added together to calculate the rate of inheritance tax. Specialist advice is essential.
We work with your financial advisors to understand your circumstances and then advise you about your options.
If you are approaching age 75 you should think about your pension beneficiary and/or their successors. Remember that your beneficiary will pay tax on what they receive from their pension at their own marginal rate so it makes sense to nominate someone who is a lower rather than a higher rate tax payer. This can sometimes be very advantageous if funds are needed for children or grandchildren. The new pension flexibility makes it possible to nominate someone who is not a dependant to receive your pension but if there is no nomination then the pension trustees will only be able to pay funds to a dependant unless there aren’t any. It is very important to have an appropriate benefit nomination in place.
So in conclusion you will need to weigh up the tax efficiencies of your pension funds versus the protection of a Pension Bypass Trust. The choice will be yours.