Legislation introduced by the Taxation of Pensions Act 2014 meant that, in the majority of cases, pension benefits are able to pass down through the generations free of inheritance tax, as long as they remain within the pension wrapper.
Therefore, if you have a straightforward family situation and are leaving funds to beneficiaries that you perceive as responsible, then passing these funds on within your pension is likely to be the best option.
However, if you have more complicated family arrangements, e.g. second marriage or stepchildren, or you want to provide for people without giving them immediate access to a large sum of money, then the use of a spousal bypass trust may lead to a better outcome.
What is a spousal bypass trust?
A spousal bypass trust is a discretionary trust that is set up by a (defined contribution) pension scheme member to receive future death benefits from their pension.
Instead of nominating individuals directly to receive the benefits of your pension, you would nominate the trust to receive them.
Doing so gives you a lot more control, as you can choose the trustees and give them instructions as to how the funds should be distributed.
* While these trusts are typically referred to as a spousal bypass trust, in reality, “bypass trust” is more accurate.
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Why set up a spousal bypass trust?
The simple answer is that it gives members more control over the future distribution of their pension funds.
While a member is able to nominate the initial beneficiary of the pension, on that persons’ subsequent death, any remaining funds will pass to the successor nominated by them, not by original memeber.
This is particularly an issue with the increase in blended families.
While the recipient of the pension fund may take the original member’s wishes into account, they have no obligation to do so.
Instead, on inheriting a pension, if a spouse remarries, they may nominate their new spouse to receive the pension benefits on their death.
Once they inherit, the new spouse may then choose to pass the funds on to their own children and ignore the original member’s bloodline.
Other instances where a spousal bypass trust could add value are as follows:
1. Where the member doesn’t think that a beneficiary should be given the option of taking a cash lump sum and they would prefer a regular income to be paid.
2. If a spouse is likely to end up in long term care.
If they receive a dependant’s pension drawdown, then this would be considered by the local authority when assessing care fees.
This would not happen if the money was in trust.
3. Where the member wants an adult child to benefit but they are concerned that the intended recipient’s marriage is rocky and that if divorce happened then any lump sum or drawdown could be considered matrimonial property.
Case study 1 – Second marriage/family
John is married to Jane at the time of death. It is his second marriage and he has step-children.
He also has adult children from his first marriage.
He has nominated Jane to receive the death benefits from his pension.
With a pension, Jane chooses who gets any residual funds on her subsequent death.
She could choose her own children over John’s adult children who would then get nothing.
It could also be that Jane remarries and leaves the funds to her new husband.
If a trust was used instead, John could instruct the trustee to provide an income for Jane in her lifetime, with any residual funds going to the children from his first marriage on Jane’s death.
Case study 2 – A beneficiary who needs protecting
Susan wants to leave her pension funds to provide for a beneficiary.
However, she is reluctant to give them access to a large sum of money in one go.
This could be for younger beneficiaries or those who lack capacity but could also include those who have a history of money problems.
With the bypass trust option, an income could be provided for such beneficiaries, or ad hoc payments made to them for purposes as defined by the member and at the trustees’ discretion.
Under a pension, this option does not exist.
The beneficiary either has full access to the funds or not at all.
What are the disadvantages of setting up a spousal bypass trust?
The main downside to the bypass trust is that the funds will be removed from a pension structure.
When it comes to pure tax efficiency, keeping funds within a pension will always be the best option.
Having the benefits paid to a trust is more complicated from a tax perspective and professional tax advice should always be taken when considering this option.
How do I set up a spousal bypass trust?
A spousal bypass trust is fairly straightforward to set up. Most pension providers offer a template version. Alternatively, a solicitor can draft one.
At the same time as setting up the trust, an expression of wishes form is filled out which requests that any death benefits from the scheme are paid to the trust.
You then appoint the trustees and instruct them on how you wish them to distribute and funds that the trust might receive on death.
Before setting up a spousal bypass trust, it is important to check how the current pension scheme distributes the death benefits.
Some schemes may have no discretion on who they pay and may be obligated to pay to the member’s estate or a particular beneficiary.
If this is the case they may not be able to accept any expression of wish in favour of a spousal bypass trust and an alternative scheme may need to be sought first.
Can I change my mind once I have set up a spousal bypass trust?
You can supersede the expression of wish form which pointed to the bypass trust by completing another expression of wish form.
The trust will still exist but no death benefits will ever be payable to it.
It is always more tax-efficient to retain funds in a pension for as long as possible.
In addition, the taxation of spousal bypass trusts is complicated and expert tax advice should always be sought.
However, if your family situation is more complex and/or your primary objective is to be able to influence the ultimate destination of the money accumulated within your pension, a spousal bypass trust can be a useful planning tool for you.
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▪️Ross has been a financial adviser for the past 26 years.
▪️He specialises in working with British expats over age 50 who are looking to optimise their finances for retirement.
▪️He is qualified as a financial adviser both in the UK, as a Chartered Financial Planner®, and in the EU, as a European Financial Planner®.
▪️Ross has been an expat himself for 22 years and currently lives in Warsaw, Poland with his wife and 2 children.