Protecting your pension from IHT
March 24th, 2014
Whilst we all hope to have a long and happy retirement it is important to consider what would happen to your pension funds if you were unfortunate enough to die prior to retirement. After all a pension fund represents a lifetime of savings and for many people might represent their largest investment, second perhaps only to their home. Typically any lump sum death benefits paid from a registered pension scheme will be paid free of Inheritance Tax (IHT) provided that the scheme has discretion over to whom such benefits are paid and the lump sum is paid within 2 years of the date of the member’s death. The scheme member can usually complete an ‘expression of wishes’ form which allows the member to nominate whom they would like the death benefits to be paid out to. Whilst the trustees are not bound by any nomination they must take the member’s wishes in to account and they would normally follow them unless there has been a significant change in the member’s circumstances since the expression of wish was completed. Commonly a scheme member will nominate their spouse which can create an IHT problem on the spouse’s subsequent death if the value of the couple’s joint assets are already close to or over the IHT threshold. One solution to this problem is to create a ‘Spousal Bypass trust’ so that any death benefits can instead be paid to a trust and therefore not form part of the spouse’s assets for IHT purposes.
How does a Spousal Bypass trust work?
A Spousal Bypass Trust is usually established by the scheme member during their lifetime with a nominal amount (for example £10). The member can then complete (or update) their ‘expression of wishes’ form and nominate the trust as the beneficiary to receive all or part of the death benefits from the pension scheme. The trust will usually have a wide range of potential beneficiaries which would include the member’s spouse as well as children and grandchildren. Importantly, when setting up the trust, the scheme member can also appoint the trustees who will make the investment decisions and have control over who, amongst the class of beneficiary’s, should benefit from the appointment of the trust income and capital. The key benefit of a Spousal Bypass trust is that, whilst the spouse can benefit from the pension death benefits, as this is at the discretion of the trustees the lump sum does not form part of their estate for IHT purposes. And whilst, depending on the value of the pension death benefits, there can be IHT charges levied every 10 years based on the value of the trust this would be at a maximum of 6% which is still likely to be preferable to potential IHT of 40% on the full amount.
What about pensions already in payment?
Any lump sum death benefits paid from schemes that are already crystallised (for example income drawdown schemes) will be subject to a 55% tax charge. However, if paid to a spouse there could be a further 40% IHT charge if the lump sum remains part of the spouse’s estate on their subsequent death so a Spousal Bypass Trust may still be a useful planning tool. A scheme can, however, allow for a dependants pension to be paid instead of a lump sum death benefit which may be preferable as this would not trigger a 55% tax charge.
Are there any other circumstances in which pensions could be subject to IHT?
As discussed, lump sum death benefits from pensions are usually free from IHT but there are traps for the unwary. Should a member be in serious ill health then an IHT charge could arise if death occurs within 2 years of the following events:-
- A substantial pension contribution is paid
- An existing pension is transferred from one provider to another (for example a transfer from one personal pension plan to another)
- Transferring death benefits in respect of certain pension plans – for example retirement annuity plans into trust
When considering Inheritance Tax it is easy to focus primarily on assets such as the family home, savings & investments and other personal possessions and overlook any death benefits from pensions (or for that matter life assurance policies you may have which are not written in trust). A Spousal Bypass Trust may not be something that is required in all circumstances but can be a simple and effective piece of financial planning that may yield a substantial IHT saving in the right circumstances. The other advantage of this form of planning is that the member can always amend an expression of wishes form at any point during their lifetime if they subsequently decide the trust is no longer required. As always, it makes sense to take advice before putting any planning in place and we would be happy to make recommendations based on your individual circumstances.
The Financial Conduct Authority does not regulate taxation and trust advice
The tax treatment depends on the individual circumstances of the investor and may be subject to change in the future