Bypass trusts – following the changes to regulations in recent years, are they still providing value and benefits for estate planning.
Given this flexibility to pay pension scheme death benefits through the generations, the question arises to whether there is still a need for the member to set up a pilot discretionary trust during their lifetime to which death benefits could be paid when the member died.
The prime objective of this trust would be to provide a wealth protection mechanism to the member’s family in the future, as well as possibly provide tax efficiency.
Could a pension fund, if it permits ongoing flexi-access death benefits, provide similar benefits in the future – with the added advantage of ongoing investments being held in a tax-free environment?
While this will clearly be a possibility, it is not thought this would be a panacea for planning for everybody in the future. The following are thought to be the relevant issues.
First, will the pension fund provide the level of wealth protection that the pension scheme member might require? This is questionable for these reasons.
A beneficiary entitled to flexi-access drawdown death benefits will be able to draw down the whole pension fund at any time. If that beneficiary went “off the rails” and drew it all out, the whole of the pension fund could be dissipated quickly.
A beneficiary entitled to flexi-access drawdown death benefits may face claims from creditors or ex-spouses. This could force the beneficiary to draw the funds from the pension scheme. The position on the vulnerability of a pension plan where the member becomes bankrupt may provide an indication to the position where, instead, a flexi-access drawdown beneficiary becomes bankrupt. If the case of Horton v Henry  EWHC 4209 (Ch) is heard by the Court of Appeal, we may obtain a better idea of the position. Current guidance from the Insolvency Service is that undrawn pension funds are not to be included as income in assessing an individual’s surplus income. However, it might be difficult to regard income drawdown death benefits as “undrawn”.
A pension scheme member who is in a new relationship or marriage may have children from a former marriage or relationship to whom he would like some of the pension fund death benefits to be paid. However, this might be only after providing financial security to their new spouse or partner during their lifetime. This can easily be organised by way of a bypass trust, but is more difficult to set up under a flexi-access drawdown death benefit arrangement.
It must be remembered that entitlement to death benefits under a pension plan will be as a result of the scheme administrator or trustees (typically an insurance company or SIPP administrator) exercising their discretion. For many this may be unsatisfactory. In these circumstances, (and assuming the scheme administrator complies with the member’s letter of wishes) the extra flexibility and control of a bypass trust may appeal because the pension scheme member can, during his lifetime, inform those personal trustees whom he would wish to benefit after his death and in what circumstances.
Furthermore, while funds are held in a flexi-access drawdown account inside a pension fund, they are not part of anybody’s taxable estate for inheritance tax purposes.
The same outcome applies with a bypass trust. But with this, they will be subject to the relevant property charges at the appropriate 10-year anniversaries.
However, inheritance tax will, in most cases, only be charged at 6% on the excess of the value of the trust fund that exceeds the nil-rate band (currently £325,000).
Indeed, further inheritance tax planning can be undertaken with a bypass trust by the trustees paying benefits to beneficiaries by way of interest-free loans repayable on demand for the borrower to spend.
As long as the loan is repaid on death, it will be a debt on the borrower’s taxable estate on death so reducing inheritance tax on the beneficiary’s estate.
Finally, investments held within the pension fund will in effect be tax-free. Investments in a bypass trust will generate income that can be taxed at up to 45% (dividends 37.5%) and capital gains tax of 28% (on gains in excess of £5,550, the trustees’ exemption).
This position can be mitigated by the trustees investing in tax-efficient investments such as single premium bonds (non-income producing) and capital growth-oriented collective investments. Hopefully, these would enable the trustees to regularly use their annual capital gains tax exemption.
Hedged bet? Is that the answer?
Ultimately, it may be difficult to predict the best route to follow. This is especially because the disposition and character of beneficiaries can change. In such cases, it may be best to “hedge one’s bets” by the member establishing a bypass trust during his/her lifetime.
Based on all the circumstances, a decision could then be made at the appropriate time on whether to pay the cash to the bypass trust or keep it in the pension fund. In out view, this is the best option – you can’t do it after you are dead!
If you are not sure if this is right for you, call us on 079 888 30691 or message on the website message system. A discussion costs nothing except your time. Getting it wrong can cost a fortune, ruin lives or family relationships.