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Pension Bypass Trusts

Introduction

This briefing provides an overview of pension bypass trusts, why they may be used and the tax implications.

Core considerations  

  • A pension bypass trust is designed to receive pension lump sum death benefits on the death of a pension scheme member.

  • No inheritance tax charges arise on a payment of pension death benefits into the trust.

  • Where the member dies before age 75 and the lump sum death benefits are within the lump sum and death benefit allowance, they are paid to the trust tax free.

  • Where the member dies after age 75, or where the lump sum and death benefits allowance is exceeded, then lump sum death benefits paid into the trust are taxed at 45%. However, payments to a beneficiary in relation to the lump sum will have a tax credit of 45%.

  • As the trust is discretionary, once payment has been made, exit and periodic charges will apply based on the date the member joined the pension scheme.

Contents


What is a bypass trust?

A bypass trust is the name given to a type of trust designed to receive lump sum pension death benefits. It is often referred to as a spousal bypass trust as it allows benefits to bypass the estate of the surviving spouse or civil partner, whilst still allowing them and other selected beneficiaries to benefit.

The most typical use of a bypass trust is for intergenerational planning where a trust can be an effective long-term way to transfer wealth. 

The pension scheme member would usually set up the trust in their lifetime (although it could be created via their will) with a nominal amount, such as £10 or a promissory note. The trust would typically be a discretionary trust. However, until a payment, for example, a pension lump sum death benefit is paid into the trust, there is only a nominal amount in the trust for the trustees to administer.

Bypass trusts also need to be registered on the Trust Registration Service (TRS) with HMRC. Trusts which hold assets with a total value of £100 or less which were already in existence before 6 October 2020 are excluded from registration on the Trust Registration Service (TRS). Adding funds to a pilot trust will remove it from the exclusion. 
 

Why would you use a bypass trust?

There are many reasons aside from bypassing a surviving spouse/civil partners estate as to why someone may wish to use a trust. 

Control and flexibility - for many clients having peace of mind that the funds haven’t directly passed to a beneficiary for them to use however they wish will be important. If the funds are paid into a discretionary trust, then the trustees have full control and flexibility in terms of making payments as and when they see fit. 

Protection of vulnerable beneficiaries - where beneficiaries are disabled or may be in receipt of means tested benefits, any funds they inherit will be taken account of for means testing. Where funds are placed in trust, the funds are essentially protected yet can be used for the benefit of the beneficiary. This equally applies in cases where a beneficiary may be going through divorce or becomes declared bankrupt as the funds will be fully protected and won’t be taken into account.

Children/grandchildren from previous relationships - having the funds paid into a trust enables the client to make sure that those they really wish to benefit will benefit. For many, intergenerational planning will also be important so that funds can be used for helping younger beneficiaries by providing for education and/or house purchase. 
 

Paying the lump sum into the trust

It is usual for the pension scheme trustees to have discretion in terms of where death benefits are paid. The pension scheme member would complete a nomination form in favour of the bypass trust to help guide the trustees in making their decision. It is possible for the pension scheme member to update such a nomination at any time should their circumstances change.
 

Trust taxation – during the settlors’ lifetime

As mentioned above, it is usual for the initial settlement to the trust to be for a nominal amount, in which case it will usually be covered by an inheritance tax (IHT) exemption – for example, the £3,000 annual exemption or the normal expenditure out of income exemption. 

As the trust is discretionary, it will be subject to the reporting requirements and charges applicable to discretionary trusts, so exit and periodic charges. However, if only a nominal amount is held in the trust there will be no tax payable or nothing to report.

In cases where the initial settlement is not covered by an IHT exemption, it will be a chargeable lifetime transfer and be subject to an entry charge if it exceeds the available nil rate band, i.e. chargeable lifetime transfers in the seven years prior to creation of the trust. 
 

Trust taxation – upon death of the settlor

There would be no IHT payable on payment of a lump sum death benefit into the trust.
However, in the Autumn Budget 2024 the Government announced a consultation to bring unused pensions and pension death benefits into assessment for inheritance tax from April 2027.

The taxation position depends on when the lump sum is paid into the trust. There are a number of scenarios with different tax treatment as shown in the table below. 

Scenario Bypass trust
Pension scheme member dies before age 75 and the lump sum is within the lump sum and death benefit allowance. Paid tax-free.
Pension scheme member dies before age 75 and the lump sum in excess of the LSDBA.

Taxed as trust income, the trustees need to pay 45% tax charge on any lump sum in excess of the LSDBA. 

When the pension funds are paid from the trust it includes a tax credit to account for the 45% tax already paid.

Pension scheme member dies before age 75 and the lump sum is not settled within 2 years of notification of death.


Death after age 75.

The lump sum is subject to the special lump sum death benefit charge of 45%.

When the pension funds are paid from the trust it includes a tax credit to account for the 45% tax already paid.

Tax free lump sums paid to the trust follow normal discretionary trust taxation rules, which means that any future payments of capital to the beneficiary are not subject to income tax.

Funds originating from pension death benefits that were subject to 45% tax when paid to the trust, are treated as income when paid to a beneficiary. The payment benefits from a 45% tax credit to reflect the tax which has already been paid. This means that depending on the beneficiary’s tax position, they can reclaim any overpaid tax from HMRC.
 

For example

Brian set up a bypass trust to receive his pension death benefits. Brian dies aged 82. The amount which was to be paid into the trust was £300,000. However, as Brian died after age 75, the payment would be subject to a 45% tax charge of £135,000. This means the trustees would have £165,000 to invest under the terms of the trust. 

If the trustees were to make a payment of say £10,000 to a beneficiary, this is grossed up to £18,182 (rounded) to take account of the 45% already paid. If the beneficiary is a basic rate taxpayer, the payment of £18,182 will be taxed at 20%, so £3,636. The amount of £18,182 was paid with a tax credit of £8,182 so the beneficiary would be able to reclaim the difference of £4,545.

Once all the lump sum has been paid out, this special tax treatment comes to an end. Any further payments from the trustees will then be treated as capital appointments and could give rise to an IHT exit charge. 


Tax on the trustees

The above gives an overview of the tax position when the lump sum is paid into the trust. It is, however, important to note that once the funds have been paid, the trustees will be responsible for investing the funds and for any income and capital gains which arise within the trust. 

The taxation of a Discretionary trust can be found in our separate briefing.

As the trust is discretionary, there may also be reporting requirements and IHT exit and periodic charges. 

  • Trust based pensions

    The anniversary date for any periodic charge calculation is taken to be the date the member joined the pension scheme (or earlier pension scheme if there had been a previous transfer). The charge is apportioned giving relief for the period in which the funds were not relevant property. 
     

For example

Betty joined her pension scheme on 1 May 1998. Her pension scheme trustees paid a lump sum death benefit of £300,000 to her bypass trust on her death on 10 June 2022.

The first periodic charge would fall 1 May 2008, then 2018 and so on.

In this case, the next periodic charge would fall 1 May 2028 at which time the trust fund is worth £340,000.

The periodic charge is calculated as follows:

Deemed transfer of value            £340,000 - £325,000 = £15,000
Notional tax                                 £15,000 x 6% = £900
Effective rate                               £900/£340,000 = 0.264%
Tax due by trustees                    *24/40 x £340,000 x 0.264% = £539
(rounded)

*The trustees benefit from relief for the number of quarters that the funds were not relevant property – i.e. from 1 May 2018 to 10 June 2022 so 16/40 quarters.

 

  • Contract based pensions

    Contract based pensions are not generally treated as settlements for IHT because the pension scheme trustees usually have no discretion in terms of making a lump sum payment. This includes ‘older’ pensions such as retirement annuity contracts, section 32s as well as some personal pensions which are established by deed poll or board resolution rather than a trust deed. They only become settlements if they’re transferred into a trust based pension or paid into a bypass trust. In these circumstances they're treated as an addition to that trust, so they don't create a separate settlement with its own nil rate band and periodic charge date.
     
  • Multiple pensions

    The tax position is more complex in a situation where the deceased had a number of pension schemes and either, consolidated them into one pension, or arranged for the lump sum death benefits to be paid to one trust. Broadly this would give rise to multiple charges arising and the need to apportion any IHT payable so usually would require specialist advice. 
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