Maybe the pensions’ lifetime allowance should be exceeded, but at the lowest possible cost? (Photo: Flickr/Rob Ellis)
The Lifetime Allowance (LTA) is the most tax efficient sum that can be accrued in a pension pot without further tax charges. For Money Purchase arrangements, and for lump sums from Final Salary Schemes it is simply the pound note value of benefits that are assessed, with Defined Benefits and other scheme pensions being assessed as 20x the pension payable.
Individuals who exceed the lifetime allowance run the risk of tax charges at the point of a “crystallisation event”; as I try to explain in this piece, the risk and downsides of these charges are often overstated for several reasons.
What happens to incur a lifetime allowance charge?
To start with, the occurrence of exceeding the lifetime allowance is not enough to trigger a tax charge. There are 13 different benefit crystallisation events (BCE) but for most people the main ones will be:
- Drawing income or lump sums from their pot (bear in mind this is not an absolute decision and, for example, someone who takes £125,000 tax-free from a £500,000 part of a £1 million pot has usually only crystallised £500,000 of their benefits)
- Reaching age 75 – this is the most predictable of all benefit crystallisation events, for most this will be the last ever time benefits are tested against the lifetime allowance
- Death – actuarially speaking this in most cases will be beyond 75 and as this is an unanticipated event for most people, there is no planning that can be done.
- Transferring pension benefits overseas – this is rarer but again would not be done without careful forethought and planning.
The full list of benefit crystallisation events can be read here, but the principal point above is to illustrate that one rarely will hit a crystallisation event without awareness or planning (death being the obvious exception) and that for those that have independent wealth, the first benefit crystallisation event can often be deferred as late as 75, with no further test being made after the age of 75.
Tax penalties for exceeding the lifetime allowance
The tax penalty is often quoted at 55%, but this is only if benefits are taken as a lump sum. Individuals who exceed the lifetime allowance essentially have three options:
- To pay any excess benefit as a lump sum less the 55% as detailed above.
- To have benefits paid as an income, which could actually be paid at the rate of nil income, and incur a 25% tax charge.
- A third option for events other than death or 75 is to avoid crystallising benefits over the lifetime allowance, for example, benefits can be drawn from 99.9% of some pensions with the remaining 0.1% of available lifetime allowance saved for further down the line (the importance of this is shown below)
As a rule of thumb the tax charge on income would be the same as the 55% tax charge. The reason for this is:
- A 25% tax charge leaves 75% to pay as income
- Income is likely to be taxed at 40% (in some cases 45% or more) given the other pension benefits in payment this leaves 60% of the 75%
- 60% x 75% = 45% that is spendable i.e. an effective tax charge of 55%.
However this rule of thumb has become less relevant in a world of Pension Freedoms where it is possible to leave lump sum death benefits to anybody, not just dependants. The effect of this change is that an individual could incur a lifetime allowance charge at the rate of 25%, and draw no income from their pot. Where death occurs before 75 the death benefit is ordinarily tax-free and even after the age of 75, an income (via an inherited ‘Flexible Access Drawdown’) that is paid to children or grandchildren, may be taxed at a lower rate than 40%.
Implications of these rules
In this example it is possible for children or grandchildren, even where the pensionholder died after 75, to pay basic rate or even lower (0%) tax on benefits when the recipients draw it out. Furthermore for individuals who die before the age of 75, any income or lump sum paid from their fund is not subject to income tax on the recipient at all (though there is still the risk of the lifetime allowance penalty charge detailed above).
I have seen individuals who have been advised to switch their pension investment assets to cash to avoid incurring lifetime allowance charges. Some of these have Fixed Protection, and this is perverse as almost by definition these people are likely to be at least 40% income taxpayers (broadly earnings over £43,000). This means any income they draw from ‘unwrapped’ investments (i.e. not ISAs) will be taxed at this rate, and even capital gains are likely to be at 28%. When compared to the 55% tax rate they may pay on pension benefits, the difference becomes less significant especially as pensions are otherwise exempted from income, capital gains, and inheritance taxes.
Retaining pension assets as a means to gift other assets
Given the above rules and new flexibilities it is now possible to leave pensions for the distant future to other beneficiaries, and it is possible that pension benefits over the lifetime allowance may only pay 25% tax charge total. For this reason, and given the complex nature of succession planning care needs to be taken to think about the consequences of this planning in the round; pensions remain accessible throughout life, without any ‘gift with reservation’ rules, which may allow them to be retained when other assets are gifted to avoid 40% inheritance tax further down the line.