Bypass Trust
What is a Bypass Trust?
A bypass trust could save you and your family inheritance tax if you have any of the following:
• a pension scheme which pays out a lump sum on your death;
• death-in-service benefits as part of your employment benefits package; or
• life insurance.
If the value of your estate is over the inheritance tax threshold (currently £325,000), when you die tax will generally be payable on your estate at the rate of 40% of the surplus.
Example
If you died today with an estate worth £1million, that would mean £270,000 in inheritance tax (40% of £675,000).
There are certain exemptions and reliefs available, for example anything left to a spouse or civil partner will be exempt from tax (the spouse exemption).
It is important to be aware of the impact that any death-in-service benefits or lump sums payable to your estate from a pension scheme or life policy may have on your estate for inheritance tax purposes. This is because any sums that become payable to your estate upon your death will generally be taken into account when calculating the inheritance tax liability.
Example
If you had assets worth £300,000 and a life policy that paid £200,000 to your estate on your death, your taxable estate would be £500,000.
It is common for life polices to be written in trust for another person, such as your spouse or civil partner, or you may have told your pension scheme provider that you wish for any lump sum to be payable to another person (often called a ‘nomination’). In the latter case, your pension provider would usually have the power to exercise discretion over the lump sum, although in most cases they would follow your wishes and pay the sum in question to the person that you have nominated.
In the above circumstances, the lump sum payable on your death would be paid directly to the relevant person and therefore bypass your estate for inheritance tax purposes. This may sound like a good thing as the sum would not be included in your estate and would therefore pass tax free to the person that you have chosen.
However, there could still be an inheritance tax problem, namely that the lump sum paid to your spouse or civil partner (or any other person) under the life policy or pension scheme would then become part of their personal estate and this could inevitability lead to a larger inheritance tax bill on their subsequent death.
Example
You have assets in your sole name worth £600,000 and a pension which provides for a lump sum of £300,000 payable on your death. You have nominated your spouse to receive the pension death benefit. You also have a will which leaves everything to your spouse.
When you die, there will be no tax payable on your estate because of the spouse exemption. Your spouse would inherit your assets of £600,000 and receive the £300,000 lump sum free of tax. If your spouse were to pass away shortly after you, however, their taxable estate would be £900,000 (not taking into account any other factors such as assets in your spouse’s sole name).
Your spouse’s estate would be eligible to transfer the unused tax threshold from your estate, meaning that their estate would benefit from twice the normal tax free threshold i.e. £650,000. That would mean tax on the surplus of £250,000 (£900,000 less £650,000), which would mean an inheritance tax liability of £100,000 (40% of £250,000) on your spouse’s death. This could have been avoided altogether through the use of a bypass trust… of their estate and potentially saving a lot of money in inheritance tax.
Example
You have assets in your sole name worth £600,000 and a pension which provides for a lump sum of £300,000 on your death (as in the example above). You have set up a bypass trust in your lifetime to receive the pension death benefit. In the trust, you have named the class of beneficiaries as your spouse, children and grandchildren. You have also prepared a separate letter of wishes addressed to your trustees stating that your wish is for your spouse to be looked after and treated as the main beneficiary. In your will, you leave everything to your spouse.
When you die, there would be no tax payable on your estate because of the spouse exemption. Your spouse would inherit your assets of £600,000 and the lump sum of £300,000 would be paid to your trustees to hold on the terms of the bypass trust.
Your trustees would have discretion over the £300,000 under the terms of the trust. Your trustees may decide to follow your wishes and subject to the terms of the trust, they would have the power to make an interest-free loan of £300,000 to your spouse, which would allow your spouse to benefit from the fund during their lifetime.
On your spouse’s subsequent death, their estate would owe the sum of £300,000 to the trust and this would be considered a debt of their estate. If your spouse died with a gross estate of £900,000, this would mean £300,000 would need to be paid back to the trust for the benefit of your children and grandchildren. Your spouse’s net estate would therefore be £600,000 (not taking into account any other debts owed by the estate).
Your spouse’s estate would be eligible to transfer the unused tax threshold from your estate. As their estate would be underneath the threshold of £650,000, there would be no inheritance tax to pay.
The above represents a simple example of how a bypass trust can be used to save potentially thousands of pounds in inheritance tax.
Another advantage of a bypass trust is that it allows you to keep a degree of control over the money you are directing into trust, as you are able to specify the class of beneficiaries eligible to benefit from the trust fund.
Depending on the amount of any lump sum being paid into the trust, there may be tax payable throughout the lifetime of the trust in the form of ‘anniversary charges’ payable every 10 years and ‘exit charges’ payable on distributions from the trust fund. However, any tax payable is likely to be relatively small in amount, especially when compared with the potential savings in inheritance tax.
If you are interested in setting up a bypass trust and/or would like further information, please telephone the Private Client team on 01992 422128.