The removal of the lifetime allowance may have further strengthened the case for beneficiary's drawdown, but this is not at the expense of bypass trusts.

That's because bypass trusts are not chosen for tax reasons. They provide a home for pension death benefits where the overwhelming priority for a client is future control over who gets what and when.

The new 'lump sum and death benefit allowance' (LSDBA) is unlikely to have any material impact on their use in the right circumstances.

However, the recent changes may still have an impact on the taxation of pension death benefits paid into a bypass trust – changes that clients, trustees and advisers alike will need to be aware of.

When are death benefits tested against the LSDBA?

Age 75 remains a pivotal age for the taxation of death benefits. Where death occurs after age 75 death benefits will be taxable but may be paid tax-free before this age.

Testing against the new LSDBA, currently £1,073,100, only applies to death benefits paid out as a lump sum on deaths before age 75. Any excess above this limit which is paid to a discretionary bypass trust will be taxable on the trustees at the trust rate of 45%.

However, there will be no test at all where death benefits are inherited under a drawdown plan or taken as an annuity. Beneficiaries will be able to draw their benefits tax-free regardless of the size of the inherited pot.

Reasons for paying a lump sum

Leaving death benefits under drawdown also means that the original member has no control over where the pot may end up on a beneficiary's death. This decision will pass to the receiving beneficiary. This may give cause for concern where there are children from a previous relationship or should the beneficiary remarry.

There may also be concerns over how the money will be used if beneficiaries are younger, vulnerable or simply can't be trusted with a large windfall. And there will be some schemes, typically DB schemes, that only pay out a lump sum.

These concerns can be managed by creating a bypass trust and instructing the chosen trustees how funds are to be applied in the future.

The LSDBA test and tax

Under the new rules, directing a lump sum to a bypass trust may come at a cost, but not always. If the lump sum is more than the member's available LSDBA, the excess will be taxed at the recipient's marginal rate of income tax. Where that recipient is a discretionary trust, the trustees will have to account for tax at the trust rate of 45%. Note that it is the trustees who must pay the tax – it is not the responsibility of the provider to deduct the tax before payment.

The tax paid will form part of the tax pool for the trustees. But this is only available for true income distributions and not payments of capital unlike the position post 75 where distributions arising from the death benefit lump sum may be treated as notional income.

Consequently, the credits in the tax pool could be lost depending on the choice of investment.

Payments to beneficiaries arising from investment bonds are treated as capital distributions. Interest from non-equity funds will suffer tax at 45% and that will match the tax credit needed to frank any distribution to a beneficiary.

That only leaves dividend income where there is a shortfall between the rate the trustees pay, and the credit needed to distribute it to the beneficiary which will get the benefit of the tax credit from the excess lump sum.

Comparison to death benefit lump sums paid after age 75

The tax position for death on or after age 75 is unchanged. There is no testing against the LSDBA, but the whole of any death benefits paid into a discretionary trust is subject to the 'special lump sum death benefits charge' of 45%. The tax is collected by the provider this time, with the trustees receiving 55% of the death benefit for investment.

The trustees also receive a tax credit for the 45% tax deducted. This can be passed on to a beneficiary when any of the original death benefit is distributed, and some or all of this can be reclaimed if the beneficiary pays income tax below the highest personal rate of 45%.

For example, a basic rate taxpaying beneficiary receiving a payment from the original death benefit of £5,500 will also get a tax credit of £4,500. Even though this is a capital payment it is still taxed as notional gross income of £10,000 in the beneficiary's hands. The tax due at 20% is £2,000, therefore £2,500 can be reclaimed.

Planning options

It is worth restating that it is crucial for clients to make their nominations for death benefits where possible. Not only does this guide scheme administrators who to pay benefits too, it also means that individual recipients have a choice over how they take benefits.

Nominations to a trust can of course only be for a lump sum, but nominations don't have to be all or nothing. A tax charge can be avoided on pre age 75 death benefits by paying an amount up to the member's available LSDBA into trust, with the balance left to individuals to take under drawdown or an annuity.

Details on how to determine the available LSDBA can be found in our guide 'Lump sum and death benefit allowance'.