Jessica List: Trusts as a beneficiaries explained

Despite rule changes, there are still a number of reasons naming a trust a trust as a beneficiary can lead to good outcomes. Jessica List explains all

Before the death benefits rules changed in 2015, nominating a trust as the beneficiary on an expression of wishes was a relatively popular course of action.

Under the previous rules, only dependants could keep death benefits in beneficiaries’ drawdown. HM Revenue & Customs (HMRC) defines dependants as any of the following in relation to a scheme member:

  • Spouses and civil partners
  • Children under age 23
  • Children over 23 still dependent due to physical or mental impairment
  • Other individuals who are:
    • Dependent due to physical or mental impairment
    • Financially dependent
    • In a mutually dependent financial relationship.

Under the pre-2015 rules, any other beneficiaries only had the option to receive a lump sum death benefit which was taxed at 55%, unless the deceased was under 75 with uncrystallised funds.

Nominating a trust as a beneficiary was a popular way to leave funds to someone other than a spouse, without them having to receive all the funds at once as a lump sum.

Once the rules changed to allow scope for any beneficiary to retain funds in beneficiaries’ drawdown, many people questioned whether there was any longer any reason to consider naming a trust as a beneficiary. However, there are still a number of reasons naming a trust can be beneficial, and below are some of the reasons discussed in recent years.

Capability of beneficiary to manage the funds

This is one of the most common reasons people might still consider using a trust. If a chosen beneficiary is unable to look after the money, whether, through age (youth or old age), medical conditions, or otherwise, a trust is a way to leave the beneficiary the money without them having to look after the money themselves.

Control over the use of the funds

Once funds are in beneficiaries’ drawdown or taken as a lump sum, the beneficiary is entirely in control over how the money is used. Sometimes people will want to leave funds to a beneficiary, but only to be used for certain purposes.

The beneficiary might be capable of looking after the funds, but the person leaving them the money might believe that the beneficiary won’t use the funds as they would wish.

Where that’s the case, naming a trust as the beneficiary and leaving detailed instructions for the trustees can enable a client to leave the money to the beneficiary and retain some control over how it’s used.

Control after death of a beneficiary

Beneficiaries who receive funds directly are in control of the funds not only during their lifetimes, but also after their deaths. By using a trust, a person can specify how he or she would like any remaining funds to be distributed after the death of the first beneficiary or beneficiaries.

Protection from third parties

If a potential beneficiary is in a financially difficult situation such as bankruptcy or divorce (or might be in the future), putting the death benefits into a trust may protect the funds from being used as part of any settlement.

Protection against future rule changes

Even though the last couple of years have been quieter in terms of pension rule upheavals, some people still fear that leaving funds in beneficiaries’ drawdown could leave them vulnerable to future rule changes. They would simply rather take their chances with a trust.

Potential tax saving

This is a bit of a tricky one, as it relies on being somewhat confident of the ages at which certain people will die. It’s best demonstrated with a quick example.

Mrs A is 73 and terminally ill. She will leave her pension to her husband, Mr A, who is 76. Mr A is in relatively poor health himself but will rely on Mrs A’s funds for the remainder of his life. Any remaining funds after Mr A’s death will be split between the couple’s two children. They aren’t confident enough of how much Mr A will need to be able to leave the children funds directly from Mrs A’s pension.

Mrs A will die before age 75, so Mr A will receive death benefits tax-free. However, Mr A is already over 75. Therefore if he kept the death benefits in beneficiaries’ drawdown, any remaining funds passed to the children will then become taxable. On the other hand, if Mrs A leaves her death benefits to a trust, the payment to the trust will be tax-free. Because the funds are then no longer subject to pension rules, Mr A’s death won’t then affect the tax position for the beneficiaries.

Of course, if the ages were reversed, the opposite would be true, and using a trust would result in all beneficiaries paying tax with no opportunity for them to become tax-free again.

Speaking of tax, this is another key consideration when looking at nominating a trust as a beneficiary. Where the death benefits will be taxable (i.e. if the deceased was over 75, or under 75 but the death benefits are distributed outside the two-year window), the payment to a trust will be subject to a 45% charge. The provider will deduct this and pay the charge to HMRC before paying the remainder to the trust.

When the underlying beneficiaries receive a payment from the trust, they pay income tax as though they also received the corresponding 45%. The beneficiary can then reclaim the 45% from HMRC. The net effect is that the beneficiary will end up in the same position as if they had received a taxable payment directly from the pension. However, it’s not a particularly easy journey to get there, especially considering that many of the situations discussed above involve beneficiaries who may not be in the easiest of circumstances to handle this kind of complexity.

Using trusts gives an individual much greater control over the death benefits and are certainly still worth considering in the right circumstances. However, the increased level of control does come at a price, which is equally worthy of consideration.

Jessica List is pension technical manager at Curtis Banks