August 2008

Bypassing the IHT bills

When retirement planning involves the use of registered pension schemes it is essential that advisers understand how to deal with any lump sum death benefit that may become payable. On the death of a member the pension fund will be distributed from the selected registered pension scheme and allocated by the trustees using guidance from the deceased. A Spousal Bypass Trust offers an opportunity to distribute lump sum death benefits while avoiding a hefty inheritance tax bill in the future.

The lifetime allowance (£1.65 million in 2008) means that the benefit values within registered pension schemes can accrue a significant value by the time a scheme member dies. Careful planning of the distribution of those values is vital.

Most registered pension scheme funds will hold the death benefits under master discretionary trusts. Under some contracts, the discretionary trust must be individually established rather than one that applies automatically to all scheme members. Where the death benefits are held under trusts, when the member dies the trustees will consider any expression of wish set out by the member during their lifetime and would normally follow the member's wishes when distributing the lump sum death benefit.

Generally speaking, such payments will be free of inheritance tax as long as they are made by the trustees within two years of the trustees becoming aware of the member's death.

Often, the lump sum death benefit is paid to the surviving spouse. The value paid to the spouse will increase the value of their estate on death, thus increasing the potential liability to inheritance tax when they die. The reality of such planning is that it simply creates an inheritance tax liability on the second death.

How these work

One way to avoid the inclusion of such lump sum death benefit payments as part of the surviving spouse's estate is for the pension scheme member to set up a Spousal Bypass Trust. In effect this is nothing more than a separate discretionary trust, set up normally for a nominal amount during the member's lifetime.

When property is placed in a Spousal Bypass Trust under which the member cannot benefit, the member will be deemed to have made a chargeable lifetime transfer for inheritance tax purposes. An entry charge to inheritance tax of 20% on the excess value will apply when the cumulative transfers over the previous seven years exceeds the inheritance tax nil rate band (£312,000 in 2008).

By setting up the trust with a nominal investment, it is likely that the 20% inheritance tax charge will not be a practical consideration as the transfer is likely to be exempt. This issue should also be taken into account when determining the suitability of this solution and addressing the cost to the client.

Under this trust the member's spouse, children and grandchildren can be potential beneficiaries but the member is excluded. The member can then advise the trustees of his registered pension scheme by an expression of wish that he would like them to consider paying to the trustees of the Spousal Bypass Trust any lump sum death benefit that may become payable from the scheme.

On the member's death, the value of the death benefits passed to the Spousal Bypass Trust will be treated as an additional payment to the trust. Therefore the death benefits will not form part of the taxable estate of the member's spouse when they later die. The trustees of the Spousal Bypass Trust will still be able to exercise discretion and pay income and/or capital to the trust beneficiaries which will include the spouse, thereby providing the spouse with access to the trust funds without the fund becoming part of the spouse's estate for inheritance tax purposes.

The future needs of the surviving spouse must be thoroughly explored before opting for this type of trust. The trust into which such payments are made is a discretionary trust and the trust may be subject to periodic charges on every tenth anniversary of the trust. It may also be subject to exit charges when any capital advances are paid to beneficiaries.

Periodic charges

The process of, determining when periodic charges and exit charges apply to bypass trust funds, especially after any registered pension scheme lump sum death benefit has been applied to the trust, can be complex. This is especially so since the introduction of the current pension regime, where it has become commonplace for clients to have consolidated existing pension assets into one registered pension scheme.

S81 Inheritance Tax Act 1984 provides that when funds in one trust are moved into another trust, those funds are treated as remaining in the original trust. As a result the ten year period runs from the date of the original trust.

In some cases, the payments of death benefits to the Spousal Bypass Trust will be made from several registered pension schemes. Each of these payments will be treated as a separate settlement, with a separate ten year anniversary date for periodic charge calculations. This will require apportionment of the trust assets for valuation purposes to determine whether periodic or exit charges will apply to the value of each portion of death benefit.

To be in a position to know when any periodic charges arise, the trustees of the Spousal Bypass Trust need to know when each pension scheme death benefit was originally established under trust, and the current value of each related death benefit.

By providing the trustees of the Spousal Bypass Trust with a schedule of the relevant slices, and the periodic charge periods and values that will apply to each slice, the adviser will ensure that any potential liabilities are correctly calculated and assessed at the correct times.

This may involve advisers in detailed work where such planning is being considered. In many cases the benefit of this analysis will be that the individual slice values will fall below the inheritance tax nil rate band, and any periodic or exit charge will be avoided.

From an adviser perspective, the benefits of using a Spousal Bypass Trust as an effective inheritance tax planning arrangement will outweigh the initial work involved in identifying the settlement dates and current values of pension funds. Demonstrating this level of knowledge will present excellent financial planning opportunities for some clients and underline the value of expert advice.

Adrian Walker
Senior Manager, Retirement Planning
Skandia