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The underused IHT planning tool that can save your clients money

The underused IHT planning tool that can save your clients money

The use of spousal bypass trusts in IHT planning is not common among advisers but understanding the way they work can help clients avoid heavy taxes on inherited pensions, writes Phillip Hasell of Blandy & Blandy.

Estate preservation planners are well versed in explaining the inheritability benefits of pensions for avoiding death taxes. In its simplest form: if you die before vesting your pension benefits, any nominated beneficiaries are likely to receive the accrued fund free of tax.

However, it is possible to plan far beyond simply nominating a beneficiary to receive a tax-free lump sum. Spousal bypass trusts are not a new concept but they are possibly one of the most underused inheritance tax (IHT) planning tools when it comes to pensions.

Advisers can help their clients by understanding the impact of pension consolidation exercises in relation to the number of 10-year anniversary dates and nil rate bands available, following death of the member.

The effect of spousal bypass trusts on IHT charges on pensions can be seen in the following examples.

Pension without spousal bypass trust

  • Jim is married to Maggie, with two children.
  • Jim’s personal pension pot is £1 million, and he and Maggie also have more than £700,000 assets each in their own names.
  • Jim dies (prior to taking any benefits) and has previously nominated Maggie to receive the lump sum benefit.
  • Soon after, Maggie dies.
  • To all intents and purposes, due to the size of her other assets, the £1 million Maggie passes on to the children (in respect of Jim’s pension) will suffer IHT at 40% (£400,000).

Pension with spousal bypass trust

  • Jim establishes a discretionary pilot trust during his lifetime.
  • Potential beneficiaries include Maggie and the children.
  • Jim dies and has previously nominated that the trust receives the proceeds of his pension on his death.
  • Soon after, Maggie dies.
  • The £1 million held in trust could be distributed to the children and as the assets never formed part of Maggie’s estate, there is a potential £400,000 IHT saving.
  • In addition, had Maggie lived a long life, assuming the trustees had appropriate powers, loans (repayable on demand) could have been made to Maggie during her lifetime. Such loans would be a debt on her estate at the point of death, which is in itself IHT efficient.

Complexity following death

Looking at the basics therefore, the principle of a spousal bypass trust appears to be somewhat of a no brainer, especially where substantial pension pots have been accrued on top of an already considerable joint estate (as the above illustrates).

The practice following death, however, can be quite complex and time consuming, particularly once the trust has received the death benefits. This can especially be the case where large pension pots come into being through a pension consolidation exercise, such as transferring two or more individual pensions into a single pension scheme.

10-year anniversaries and nil rate bands

A spousal bypass trust is a discretionary trust, which is subject to potential 10-year periodic charges and exit charges of up to a maximum of 6% of the value of the trust that exceeds the available nil rate IHT band.

It is not, however, always as simple as there being one 10-year anniversary and one nil rate band (NRB). Consideration needs to be given to the original scheme being transferred in terms of the type of scheme (contract or trust based) and consequently if and when a settlement into that scheme was ever made. Consider some examples in relation to pensions consolidation:

Example 1

Jim’s £1 million is held in a trust-based pension (Sipp) and he has set up a pilot discretionary trust with a nominal sum of money. He has nominated that on his death, the pension death benefits are paid into the trust. The £1 million came about due to two pension transfers with the original schemes both being trust-based pensions. In this example, the trustees are likely to have to consider thee different 10-year anniversary periods:

  • One in relation to each of the transfers, with the reference date being the date on which the original pensions were started;
  • One in relation to the pilot discretionary trust at the date it was set up.

There is also the possibility, depending on when each trust was created that up to three NRBs would be available.

Example 2

The scenario is the same as above but with new contributions made into the Sipp. In this example, there is an extra 10-year anniversary period, and potential NRB, as the new contributions into the Sipp would be considered a new settlement.

Example 3

Assuming all of the transfers into the trust-based Sipp were contract-based pensions (eg, retirement annuity contracts), there are only likely to be two different 10-year anniversary dates, and associated NRBs:

  • One in relation to the date the Sipp commenced;
  • One in relation to the pilot discretionary trust at the date it was set up.

As the contract-based schemes are not considered to be settlements at the time they commenced, the funds only become settled property on their transfer into the Sipp. Note that whether or not there were new contributions into the Sipp, this will not affect the number of settlements or NRBs in this case.

An opportunity

The above examples are not intended to be exhaustive; a pension consolidation exercise is often made up of transfers from both contract and trust-based schemes. The general principles above can, however, be applied and highlight the potential extra administrative duties of trustees and the need for advisers to keep detailed records of any transferred schemes.

Perhaps one of the reasons why spousal bypass trusts are not considered more often is that the advice falls into two areas of expertise: financial planning and trust planning.

Financial planners possibly do not have sufficient technical knowledge to fully understand the nature of trusts and their implications to give advice confidently.

Conversely, solicitors understand the technical nature of trusts and their practical workings without having the practical knowledge of the varying types of pensions and their idiosyncrasies.

This could be an opportunity to work together.

Phillip Hasell is a chartered financial planner at Blandy & Blandy.

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