Pensions Freedoms: The end of Spousal Bypass Trusts?
One overlooked element of the government’s pension changes is their impact on the relevance of spousal bypass trusts (SBT) for personal pensions. This article will outline recent changes to pension legislation, detail the factors to consider in electing to retain lump sum pension benefits or using an SBT as an alternative, and conclude by considering whether SBTs are now no longer relevant in pension death benefit planning.
What is a Spousal Bypass Trust?
The expression is a marketing term which legal professionals may understand as a discretionary pilot trust. An SBT is typically used to minimise inheritance tax on the death of a surviving spouse, as it keeps the pension lump sum outside of their estate while allowing said spouse to draw an income from the pension lump sum during their lifetime. The lump sum passes into the pilot trust on death provided a non-binding expression of wishes form is completed for the pension trustees to take into account.
Pension arrangements are brought into the surviving spouse’s asset calculations in divorce, bankruptcy and residential care costing scenarios, whereas the value of an SBT has been excluded in such cases. The inheritance tax and asset calculation rules meant SBTs featured prominently in pension death benefit planning. More recently the usefulness of an SBT has been brought into focus courtesy of changes affecting the taxation position of the assets held within a pension wrapper on death.
On September 29th 2014, the Chancellor announced the removal of death tax on the value of pensions lump sums from money purchase funds (AKA non-final salary pensions) on death through the Taxation of Pensions Act 2014.
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Until the end of the 2014/15 tax year, this 55% tax applied where: –
- The deceased was under age 75 AND the pension had been drawn on – ‘crystallised’
- The deceased was over 75 at date of death whether the pension was crystallised/uncrystallised
It should be noted that a lump sum payment where the deceased died before 75 would be paid tax-free. There are ways to take an income from a pension – e.g. an annuity – provided the recipient is 55 or more.
The position Post 5th April 2015
The 55% tax was abolished in all pensions lump sum payment situations where the deceased was under 75 provided: –
- Benefits are paid within two years of death
- An ‘Lifetime allowance tax charge’ (LTA) is not triggered (I won’t discuss this within this article).
For cases where the deceased had reached age 75: –
A lower 45% tax charge is currently applicable to a lump sum payment on death during the current 15/16 tax year, with the government proposing from the 2016/17 tax year onwards such cases will be taxed at the beneficiaries’ marginal income tax rate*.
Other Factors for Consideration
In selecting whether an SBT is appropriate for clients, factors outlined such as client age, and whether the client’s pension is ‘crystallised’ should be considered; in conjunction with others highlighted below.
Inheritance Tax position on First Death
It is generally accepted that provided a pension is paid to a nominated beneficiary on death within two years, it is excluded from the deceased’s estate for IHT purposes. Note that if a surviving spouse elected to retain the value of the pension within the pension wrapper, the new pension legislation outlined earlier applies, with associated tax charges – although any charge applicable is not an IHT charge.
HMRC treat the payment of a lump sum death benefit payment from a registered pension scheme to an SBT as a settlement, and the same two-year time limit applies to transfers from the pension wrapper to an SBT as it does on death benefit transfers to individuals. Periodic and exit charges may be applied where the funds remain within the SBT for ten years or more however – an important point to bear in mind should the funds be likely to remain in the SBT for some time and the periodic/exit charges apply.
Ongoing Income Tax/CGT on the funds
Pension fund growth is effectively tax-free, with any lump sum payment on death not subject to an income tax charge/or deemed a disposal for CGT.
By contrast, the relevant property regime tax treatment rules apply to the SBT. A £5,550 CGT allowance applies to any gains in the 15/16 tax year, with a tax of 28% applicable thereafter. Income to £1,000 is taxed at 20% with any income in excess taxed at 45%. The SBT trustees can place the funds into an investment bond, reducing the need for taxation administration while improving tax-efficiency – although this is not without cost.
Tax Position on second Death
The tax treatment on second death is in-line with that of the first death (as above) where the dependent is under/over age 75.
The recent legislation changes have facilitated a wider range of potential beneficiaries – not just dependents, but so called nominees or successors.
- Nominees are individuals (not necessarily dependents) who are referred to in an expression of wishes form for uncrystallised pension funds.
- Successors are those, again not necessarily dependents, referred to in in an expression of wishes form for ‘crystallised funds’ – in drawdown.
The key point here is that wealth within pensions which was previously extinguished on the death of a dependent, is now allowed to cascade down families more readily by virtue of the legislative changes which allow non-dependants to benefit from the capital within the pension.
Note however the current probability of both husband/wife alive today failing to reach age 75 is 7%.
The SBT is unaffected by the second death; an IHT exit charge may be payable after the first ten-year anniversary, should capital be advanced from the trust to children, or other nominated beneficiaries.
Client Life Expectancy
Where it is reasonably believed the client will not reach their 75th birthday, under current legislation there may be merit in retaining the pension within its wrapper which the beneficiary can receive this without a tax charge. This is not the case for life expectancies taking clients beyond age 75 with a tax charge applicable, noting that HMRC take a keen interest in any attempt to strip funds from within a pension where clients may need to go into residential care.
Where a lump sum death benefit payment is made into an SBT and periodic and exit charges for IHT apply, there may be significant ongoing charges particularly where the deceased dies relatively young, leaving the remaining spouse potentially with a number of years to draw on the lump sum death benefit from within the spousal bypass trust.
Making Loans from the Wrapper
On death, a loan can in theory be made from either the pension or SBT to a beneficiary. The rules surrounding pensions would make this expensive and difficult in many cases, and impossible in a wide range of existing pension plans.
An SBT would be able to facilitate such loans which would not impact the trust fund itself with trustees becoming creditors in effect. For the beneficiaries, there would be no addition to their estate for IHT purposes.
Have the recent legislative changes put an end (for now) to the spousal bypass trust in pension death benefit planning? No. However, there can be no doubt that the recent legislative changes surrounding pension death benefits have increased the range of scenarios where retaining pensions within their wrapper is more advantageous than the use of an SBT – particularly where wealth preservation is viewed as a primary objective.
There are a range of factors that one must keep in mind including those highlighted above in making decisions on the appropriateness of an SBT or otherwise. Given the spotlight on pensions politically, in addition to the potential for future revisions to applicable legislation, the need for regular reviews factoring in prevailing pension legislation – and a client’s personal and financial circumstances – is of greater importance than ever before.
*There is scope in the current legislation for IHT to apply on the transfer of drawdown funds but it is widely expected that this is an oversight by HMRC and appropriate amendments to the legislation are to be made shortly.
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