Confirmation in the Summer Budget 2015 that certain lump sum death benefits will be taxed at an individual’s marginal rate of income tax, with effect from 6 April 2016, (as opposed to the current 45% tax charge), is further good news regarding the new taxation regime for death benefits.
However, confirmation that the 45% charge will continue to apply where the recipient is not an individual, leads James Jones-Tinsley to question if this is yet another ‘nail in the coffin’ for spousal bypass trusts?
Twenty years ago, when I worked for Scottish Widows, (and – no – I didn’t flounce around in a black hooded cloak), the Financial Planning Manager there taught me at great length about the history, uses, and tax-efficiency of trusts - particularly where life assurance and pensions were concerned.
"Despite their surgically-sounding name, spousal bypass trusts became popular during the late nineties, and throughout the noughties, as a useful means of circumnavigating the estate of the surviving partner."
That training has stood me in good stead ever since; particularly given my subsequent involvement in trust-based pension arrangements, and the use of ‘spousal bypass trusts’ for Drawdown death benefits.
The primary advantage of trusts that was continuously drilled into me was the potential for the settlor to control what would happen to their life assurance or pension funds, ‘from beyond the grave’; particularly where significant monetary amounts could otherwise be inherited by younger relatives, who did not necessarily possess the desire to ensure that the money was invested wisely for their future.
The manager demonstrated the potential for this juvenile profligacy through use of the phrase 'motorbike and leathers'; conjuring up a decadent recklessness that a trust could otherwise serve to prevent.
Despite their surgically-sounding name, spousal bypass trusts became popular during the late nineties, and throughout the noughties, as a useful means of circumnavigating the estate of the surviving partner, whilst also allowing them – in their capacity as both a trustee and potential beneficiary - to receive a (potentially interest-free) loan from the Trust which, if still outstanding on their eventual death, constituted a debt on their estate for inheritance tax-mitigation purposes.
Importantly, at this time, the income tax charge for drawdown lump sum death benefits was the same, regardless of whether they were paid directly to an individual, or to a trust. As a result, the latter was often preferred over the former by financial advisers as a tax-efficient estate-planning tool.
The two exceptions to this is where the pension member dies aged 75 or over and their fund is passed on as a lump sum, and where the pension member dies under age 75, but their fund is not distributed by the pension provider until after two years following their death. In both cases, the lump sum is currently subject to a 45% income tax charge, regardless of who it is distributed to.
"Where the recipient is not an individual, (defined in the legislation as a ‘non-qualifying person'), the 45% tax charge will continue to apply. And one example of a ‘non-qualifying person’ is a spousal bypass trust."
Last month’s Summer Budget offered more good news where these two current exceptions are concerned.
With effect from 6 April 2016, (provided that the draft legislation makes it onto the statute books unamended), lump sum death benefits from those aged 75 or over, or paid out after two years following the death of someone aged under 75, will not be subject to the 45% tax charge, but will instead be taxed as pension income, at the recipient’s marginal rate of income tax.
However, where the recipient is not an individual, (defined in the legislation as a ‘non-qualifying person'), the 45% tax charge will continue to apply. And one example of a ‘non-qualifying person’ is a spousal bypass trust.
Therefore, there is a strong argument that this final ‘twist of the tax knife’ may see off Spousal Bypass Trusts as an estate-planning tool, once and for all.
But – I still hark back to the trust training I received all those years ago and, given today’s complicated family structures, and the possible financial irresponsibility of potential beneficiaries, I would maintain that – despite the ever-improving tax efficiency of retaining death funds within a pension environment - there will always be situations where spousal bypass trusts constitute the most appropriate destination for a lump sum death benefit distribution.
Particularly where the deceased would not want to see their offspring riding off into the sunset on a shiny new Harley Davidson.
This blog first appeared on Professional Adviser in August 2015