Bypass trust

A bypass trust is an ordinary discretionary trust which is used to receive and manage death benefits paid from a pension scheme upon the death of the settlor. As a discretionary trust, it is not limited to only holding pension death benefits and can hold other monies if desired.

1.Why might you use a bypass trust

A bypass trust is mainly used to prevent lump sum payments made to a surviving spouse/civil partner from forming part of their estate if they don’t spend the money before they pass away.

It can also help the person setting up the trust (the member) keep some control over where the money goes. For example, they might want their spouse to benefit first (either by paying money directly or by making a loan to them that is repayable upon demand) but then want their children to receive what’s left after the spouse dies. If the lump sum is given directly to the spouse, the spouse decides what happens to it later. They could leave it to someone else, like a new partner or children from another relationship.

With a bypass trust (a discretionary trust), the trustees will likely follow the member’s wishes. The spouse can still benefit, but the money doesn’t automatically become theirs. This means it can be passed on to the children later, and someone like a new spouse wouldn’t be able to benefit unless they’re named in the trust.

Other potential uses include:

• Holding funds for beneficiaries until they reach a specified age, allowing for controlled access to the inheritance.
• Managing money on behalf of vulnerable beneficiaries who may not be able to handle financial matters independently or responsibly.

2. Tax on death benefit being paid into trust

Whether a lump sum death benefit paid into a trust is taxed depends on several factors:

• If the member dies below age 75, it is paid within 2 years of notification of death and the lump sum is within the Lump Sum and Death Benefit Allowance, it is tax free.
• If the member dies before age 75:
  • And the lump sum exceeds the remaining Lump Sum and Death Benefit Allowance: The excess is taxed at the recipient’s marginal rate. For a discretionary trust, this is 45%.
  • And the lump sum is not paid within 2 years of notification of death: The entire amount is subject to the special lump sum death benefit charge at 45%.*
• If the member dies aged 75 or older:
  • The entire lump sum is taxed at the special lump sum death benefit charge of 45%.*

* If this is later distributed to a UK individual, the beneficiary receives a tax credit for the 45% charge. They may be able to reclaim some or all of this from HMRC.

3. How Inheritance Tax Charges Work in a Bypass Trust

Discretionary trusts are classified as relevant property trusts under inheritance tax (IHT) rules. This means they are subject to periodic charges every ten years, as well as exit charges when capital is distributed from the trust.

Payments made into a pension scheme are not treated as chargeable lifetime transfers. As a result, when evaluating potential trust-related tax charges—such as entry, periodic, or exit charges—you only need to consider chargeable lifetime transfers made outside of the pension.

Typically, the cycle of IHT charges begins from the date the trust is established. However, when death benefit payments from pension schemes are involved, the position can become more complex.

4. Tax after money is within the trust  

These are the tax rules that apply after the money enters the trust:

Income Tax

• Trustees pay income tax at 45% (or 39.35% on dividend income).
• There is no dividend allowance for trustees.
• Trusts with total income under £500 in a tax year are exempt from income tax.
• If the settlor has created multiple trusts, the £500 exemption is shared across all of them. With a minimum exemption of £100 per trust.

Capital Gains Tax (CGT)

• CGT is charged at 24% (32% for carried interest).
• Trustees receive half the standard annual CGT exemption.
• This CGT allowance is shared among all trusts created by the same settlor. With a minimum exemption of £300 (2025/26).

Tax Pool and Beneficiary Payments

• Income tax paid by trustees is added to the trust’s tax pool.
• When income is distributed to a UK beneficiary, the tax pool provides a tax credit of 45%.
• Beneficiaries may be able to reclaim some or all of the tax from HMRC, depending on their personal tax circumstances.