A spousal bypass trust is effectively a pilot trust, set up by a settlor in his or her lifetime, to benefit their surviving spouse after death. The policy funds (a lump sum) are placed in trust upon the settlor’s death.
It is usually set up so that a surviving spouse receives benefits from a pension scheme, with its aim being to ringfence its benefits from the settlor, or the surviving spouse’s, estate on death and from any potential inheritance tax (IHT) that may be due on their individual estate.
The trust itself is the nominated recipient, as opposed to the named beneficiary, and is separate from the pension plan. This allows the trustees to make payments to the nominated beneficiary without it forming part of their estate. Trustees are also able to provide loans to the beneficiary, the debt of which is considered on their death, in turn reducing their estate and any potential IHT.
A spousal bypass trust is subject to periodic charges every ten years at a maximum rate of 6% of the value of the trust.
This periodic charge depends on how the trust is set up, i.e. if it is a trust-based pension scheme, the charge is calculated from the date of joining the original pension scheme; if it is not a trust-based pension scheme, it is calculated from the date on which the funds are paid into the trust.
The relevance of a spousal bypass trust recently came into question following the pension reforms in April 2015.
The reforms are best divided into two categories, those in which a member dies under the aged of 75 and those aged over 75.
Under 75: A member who dies before the age of 75 can nominate a beneficiary to receive death benefits free of tax from both crystallised and uncrystallised funds.
The nominated individual (beneficiary) can choose how they receive the benefits, i.e., as a lump sum or income. Both a lump sum and drawdown of the pension are free of tax.
It is important to note that, if a lump sum is paid out in full, all pension rights with that particular pension provider are terminated: the lump sum forms the beneficiary’s estate for the purpose of IHT.
If the lump sum is paid into a spousal bypass trust, it will be considered a discretionary trust for the purpose of IHT.
Over 75: If a member dies after the age of 75 they can nominate an individual (beneficiary) to receive death benefits.
If such benefits are taken as an income by the beneficiary, they will be subject to income tax. At present, there are no restrictions as to the amount of withdrawals that can be made by the nominated beneficiary.
Another alternative, and temporary (until tax year 2016/17), option is for the beneficiary to receive the benefit as a lump sum payment. This is subject to a 45% tax charge.
If a lump sum is placed into a spousal bypass trust, this tax charge will also apply. The 45% tax charge is due to change to the beneficiary’s marginal rate in tax year 2016/17. This will not affect spousal bypass trusts, as their rate of tax, and therefore their marginal rate, is 45%.
The new rules also allow the original nominated beneficiary to pass on any unused drawdown funds, on their death, to their own nominated beneficiary. The above tax treatment will apply, but will be dependent on the age at date of death of the beneficiary, and not the original policy member.
This potentially allows pension funds to pass down from generation to generation, without falling into an estate for the purpose of IHT. Such benefits have the potential to provide tax-free income for generations – until a beneficiary dies before reaching 75.
As illustrated by the new pension reforms above, the spousal bypass trust is therefore no longer an attractive option. The pension reforms not only eliminate potential periodic and exit charges but allow funds to remain in a structure that will produce growth and income.
The new rules do not mean that spousal bypass trusts are in no way beneficial. Spousal bypass trusts can be drafted to be tailored to the individual’s needs, and can be an effective tool for providing for children from a previous marriage, protecting funds from creditors and state benefit purposes, including long-term care.