How useful is the spousal bypass trust in light of the pension reforms?

Prior to April 2015, if a pension investor died before the age of 75 (in drawdown), there was a 55 per cent income tax charge if death benefits were taken as a lump sum. From April 2015, such lump sum payments on death are tax-free (regardless of whether the investor is in drawdown).

In addition, if a pension investor died after the age
of 75, lump sum death payments were taxed at a rate of 55 per cent, even if the investor was not in drawdown. This rate has now been reduced to 45 per cent for the tax year 2015/16. For the tax year 2016/17 onwards it is proposed that the benefit will be taxed at the recipient’s marginal rate of tax – but that provision is not yet enacted.

Pre-April 2015, spousal bypass trusts (SBT) played an extremely important role in relation to effective inheritance tax (IHT) planning with pension lump sum death benefits. SBTs are set up by the settlor during their lifetime to receive the lump sum on death and are often drafted as discretionary trusts with the surviving spouse and children named as beneficiaries. The aim is to prevent the death benefits falling into the settlor’s or surviving spouse’s estate on death and potentially subjecting them to IHT.

Clients frequently saw the advantages of using an SBT pre-April 2015 to mitigate IHT
on what is often a large asset. Post-April 2015, commentators consider that it may be more difficult to convince clients of the benefits, especially in light of the fact that now if the settlor dies pre-75 the lump sum payments can be taken tax-free. However, SBTs remain enormously useful for several reasons.

Future changes

Currently, it is possible for named beneficiaries to take a lump sum death benefit payment tax-free
if the settlor dies pre-75. However, there are potential issues relating to increased IHT
in the survivor’s estate and asset protection.

Where the settlor dies
pre-75, and the surviving spouse receives a survivor pension and survives post-75, under the current rules (and in the current year) the funds would be subject to a 45 per cent tax charge on extraction as a lump sum. Contrast this to the situation where an SBT has been created and the surviving spouse can continue to receive a benefit
of capital and/or income, which effectively banks the tax-free benefit.

The SBT could also protect against future changes to the pension rules which may affect the ability to take a tax-free element. Relevant property
trust regime charges should be considered; however, these would need to be significant in order to offset the advantages of protecting the sum against a tax charge.

Trustee flexibility

The settlor may wish to give
the lump sum to named beneficiaries but will not know whether they will be in a position to receive the assets, for example, due to divorce, bankruptcy, or dislodging means-tested benefits.

Settlors invariably require their trustees to have flexibility to review each beneficiary’s personal circumstances before making a distribution. Often the settlor’s primary consideration is their surviving spouse.

Asset protection

With second marriages, or
where there is a chance of re-marriage, SBTs provide a measure of protection for children from the first marriage. Also, where SBTs have been used, trustees could prevent the second spouse accessing the lump sum during their lifetime, which they may otherwise have been able to do under the new flexible arrangements.

Settlors should review and update their wishes in a nomination form (which tends
to be kept short and clear) and forward this to the pension trustees during their lifetimes
to ensure they are aware of the wish to use the SBT, in particular where there is more than one pension fund.

The settlor should also
provide a carefully drafted
letter of wishes alongside the nomination, including asset protection objectives, which pension schemes do recognise. Be careful to provide clear wishes, as different pension administrators deal with nominations in different ways and they ultimately have discretion.

In addition, where the settlor has had a number of pensions during their life, it is possible
to consider making use of available nil-rate bands (i.e. utilising a different SBT for each pension fund). This is particularly important with large pension pots to assist in minimising ten-yearly charges.

To conclude, SBTs continue
to play an extremely important role in respect of the effective IHT planning of pension lump sum death benefits, in particular given the future uncertainty relating to the rules. The practical uses of the SBT should not be forgotten, as these are becoming increasingly important given the evolving nature of modern families. The pension changes, while welcomed by many, create more complexity and a higher risk of ‘wrong decisions’, and therefore it has never been more important for investors to take advice from legal and financial professionals when planning for their retirement. SJ

Louise O'Toole is a solicitor at Thomas Eggar