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.