We wanted to look at a type of Trust which will safe-guard your loved ones inheritance from divorce.
As a married couple, if your total estate including your pensions exceeds the nil-rate band (currently set at £650,000 for a couple), your next generation are likely to be faced with a 40% Inheritance Tax bill on the excess. It is also worth considering that the UK has the highest divorce rate in the EU. With this in mind, it seems a shame to work hard to save into your pension, only to have some or all of it taken away from your family by the state or from a divorce in the family. A special type of trust for your pension can help to safeguard this valuable asset against these issues.
Trusts are a very cost effective way to protect your family’s assets and to reduce your Inheritance Tax (IHT) bill. However, many people are oblivious to the issues that can arise without them. Trusts provide probably the best protection when it comes to making sure that everything you have worked hard for stays in the family. The Spousal Bypass Trust is a specific way of using a traditional trust arrangement to protect your pension fund; often the second largest asset someone has. So how does it work? The best way to answer this is to look at an example of what usually happens without one.
Mr and Mrs Smith have a joint estate worth £1 million, plus Mr Smith has a pension policy worth £500,000 and has nominated Mrs Smith as the beneficiary of any death benefits.
On Mr Smith’s death before retirement, Mrs Smith inherits the whole estate, including the pension as a tax free lump sum. No Inheritance tax here, so all seems fine at this stage.
The problem arises when Mrs Smith dies. At that point, the pension value is now added to the estate, so her total estate is now £1.5m. As a result, Mrs Smith’s Inheritance Tax liability after the joint nil rate band (£650,000) would be £340,000.
That is a significant reduction to the family’s wealth, but this could have been worse. What if Mrs Smith had remarried Juan, and then divorced him later in life? That might have cost the family £750,000. Or worse still, what if Mrs Smith had remarried Juan and then died; that could cost the family the full £1.5m if Juan gets his hands on it! Finally, if Mrs Smith went into long term care at a typical cost of £48,000 per annum, the estate will rapidly be eroded.
So how would a Spousal Bypass Trust help?
Nothing changes during Mr Smith’s lifetime other than the need to assign the death benefits of the pension to the Spousal Bypass Trust that has been created. On Mr Smith’s death, the death benefits pass to the trust. Family or friends, including Mrs Smith, are trustees to keep the running costs to a minimum, and they make an interest free loan of the full £500,000 to Mrs Smith.
Mrs Smith can use the funds as she needs during her lifetime, but on her death the funds can return to the trust to be reallocated to the children. This would save Inheritance Tax on the £500,000 that had come from the pension, an immediate tax saving of £200,000.
Furthermore, if Mrs Smith had got remarried to Juan and then divorced, the £500,000 is not her asset but a loan, so the Trust should ensure that is excluded from the divorce settlement. Equally, if she remarried and then died, whilst the rest of the estate may go to Juan, the £500,000 will return to the trust and pass down to the children. The same protection would apply against care costs too.
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