Before the recent pension changes were announced, it made sense, for Inheritance Tax (IHT) planning purposes, to request that any death benefits payable from a money purchase private pension on the pension scheme member’s death were paid into a separate trust (a ‘bypass trust’), usually for the benefit of the member’s spouse and family. Structuring matters in this way would prevent what could sometimes be significant sums from being paid direct to the surviving spouse, with the potential for any unspent funds to be taxed at 40% IHT on the surviving spouse’s death. On the other hand, by using the trust route, the spouse could still enjoy full access to the pension funds via loans made from the trust, which have the potential to be deductible for IHT purposes on the survivor’s death.
Another attraction of this arrangement was that the trust could have a class of beneficiaries, with no restriction on who appeared in the class. Unborn grandchildren could be included, for example. In contrast, under the old pension plan rules, death benefits paid as drawdown income could only be paid to a narrowly drawn list of the pension member’s dependants, not including adult children over 23. But under the new pension rules, the member (or subsequent beneficiary) can specify anyone to receive flexi-access death benefit pension income – they no longer need to be a dependant. And the fact that they have the ability to draw down on those funds does not mean the funds are in their estate for IHT purposes on death.
Does this mean that pension death benefit trusts can be consigned to history? Not necessarily, I think. It will depend upon each member’s attitude to those important factors of tax and control.
First let’s look at the tax factor. This will depend on the age at which the pension scheme member died. If under age 75, a lump sum payment (to a bypass trust or an individual) will be tax free. So will flexi-access income drawdown – if taken. If the member died aged 75 or over, the lump sum would be taxed at 45% in 2015/16. Flexi-access income drawdown will be taxed at the recipient’s rate of Income Tax. It certainly looks more attractive to pay a lump sum to a bypass trust if the member dies before age 75.
If a lump sum is paid to the bypass trust, the funds then representing the pension death benefits will be subject to the usual tax regime applicable to trust income, capital gains and periodic charges to Inheritance Tax. With trustees paying Income Tax at 45% on some income, this regime is none too friendly but can be managed with a careful investment policy. None of these issues apply if funds remain within a flexi-access account as until drawn they will continue to accrue in the tax free wrapper that applies to pension schemes.
Now let’s look at the asset control factor. People concerned about asset protection and control may be less keen on flexi-access pensions. This is because a named drawdown beneficiary could remove the entire pension fund supporting their income stream and spend it as desired. The fund would also be exposed to claims on the beneficiary’s wealth from divorcing spouses, ex-cohabitees or creditors of a failed business. The current nominated beneficiary can also direct whom the pension fund passes to on their death. In contrast, the income stream from a bypass trust of pension death benefits can be given to one beneficiary, say the surviving spouse of a second marriage for their lifetime, and then reallocated after that spouse’s death to the children of the deceased’s first marriage. The surviving spouse’s will cannot control what happens to the bypass trust funds on the survivor’s death.
At the end of the day, in order to maintain IHT freedom, the question of who receives flexi-access death benefits at any given time is at the discretion of the pension scheme administrator. If families want to retain control of the matter within the family unit, getting death benefits paid to a bypass trust, coupled with well chosen, trusted family trustees, may be the preferred option.
Some pension members might like to keep their options open by creating a bypass trust with a nominal sum now and lodging a letter of wishes with their pension administrators requesting that they be guided by the pension member’s executors as to whether to transfer death benefits to the trust. As is often the way with estate planning, there is no ‘one size fits all’ approach and pension members will require bespoke advice.
Helena is indebted to John Woolley of Technical Connection for his input into this blog.