In April’s Financial Update, I discussed the increased threat of the lifetime allowance (LTA) on pension savings, particularly following a five-year freeze to the standard LTA announced in the Budget in March 2021.
The LTA is set by the government and is the maximum tax efficient value of all your retirement benefits excluding the State Pension. Your pension benefits will be tested against the LTA when you start to take them, on death, or at age 75 if earlier. If the value of all your pension benefits exceeds the LTA, set at £1,073,100 (tax year 2021/22), a lifetime allowance tax charge is applied on the value of your benefits in excess of the allowance. A flat rate tax charge is applied on the excess at 25% if used to provide a taxable income or 55% if taken as a lump sum.
How to tackle the lifetime allowance
The lifetime allowance tax charge is only payable when you have used all of your available LTA. When and how you take your pension benefits can have a significant impact on the amount of tax charges, so there are strategies which can be used to access funds when you need them and pay any lifetime allowance charge when it best suits you.
If you only access part of your pension fund before age 75, then you only need to pay a charge if the value of the benefits which you access exceeds the LTA. You can use funds up to the LTA to provide pension benefits by designating them to drawdown and or purchasing an annuity, leaving the remainder – the excess – uncrystallised.
However, any remaining uncrystallised benefits will tested at age 75 or if you die before age 75 when a lifetime allowance charge may be payable. The growth on any crystallised fund will also be tested against the LTA at age 75.
If you have a defined benefit (final salary) pension, the annual pension payable is multiplied by 20 when it commences to determine how much of your LTA is used up. You can generally take out 25% of the value of the pension as a tax free lump sum and doing so will reduce the LTA calculation as the cash is deemed to have been taken at face value.
If you exceed the available LTA, you could enjoy potential investment growth and resign yourself to paying a lifetime allowance charge. After all, you benefit from a larger fund value and paying a tax charge may not be an unacceptable outcome. However, the value of your investment and income from it can go down as well as up and you may not get back the full amount you invested.
A case study can demonstrate these two options:
1. Paying the lifetime allowance charge – If Ben, aged 60, has total pension savings of £1,573,100 with no LTA protection and no other sources of income, and he chooses to access the full fund, his fund can provide :
Maximum tax free cash of £268,275
A lifetime allowance charge on the excess at 25% of £125,000 (assuming taken as income)
Drawdown fund of £1,179,825
Ben would need to make withdrawals from the drawdown fund to avoid a second lifetime allowance charge at age 75 and keep the drawdown fund at £1,179,825. However the withdrawals would be subject to his marginal rate of Income Tax.
2. Delay the lifetime allowance charge – If Sarah, also aged 60, has the same fund, but chose to only take benefits up to the LTA, she would have £500,000 uncrystallised.
At age 75, she will face two assessments for lifetime allowance charges, firstly on the investment growth of the drawdown fund (if applicable) and secondly on the full value of the uncrystallised funds.
The lifetime allowance charges payable at age 75, or on death before age 75, will depend on potential investment growth.
Both Ben and Sarah will incur lifetime allowance charges, but their chosen strategy will depend on their own circumstances.
Other options include phasing benefits to suit income needs, but when benefits exceed the LTA, the charge will be payable.
Consider alternative investments
If you have reached the LTA, you may consider other investments which may also be subject to annual allowances such as Individual Savings Accounts, Venture Capital Trusts or Enterprise Investment Schemes which could be used to provide income in retirement. Don’t forget you can also consider making pension contributions to a spouse/civil partner’s pension who will also have their own LTA.
Is it worth paying a lifetime allowance charge?
Generally, people should look to manage their pension savings within the lifetime allowance limits. However, you may benefit from exceeding the allowance and paying a tax charge in some situations such as:
1. Employer matched contributions to your pension mean that your contribution is in effect doubled, so you make a valuable gain even after the lifetime allowance charge.
2. Pension funds are generally exempt from Inheritance Tax (IHT), so you may prefer to pay the lifetime allowance charge when you die rather than the 40% IHT which would apply if these funds were to remain in the value of your estate.
3. Defined benefit pensions offer valuable guaranteed benefits which will normally make any LTA tax charge worth paying.
What should you do?
If you do think that you are likely to exceed or have exceeded your liftetime allowance, we recommend that you seek financial advice, so that we can help you make decisions which suit your circumstance and financial objectives. It is therefore essential that this is factored into your strategy to ensure you meet your retirement objectives whilst minimising any lifetime allowance tax charge where possible.
Ask your Origen adviser how you can build a strategy which helps you towards your financial goals most effectively. We can provide recommendations on how to protect your pension savings, take your retirement benefits or recommend alternative actions to best suit your financial needs
This update is intended to be for information only and should not be taken as financial advice.
The value of your investment and income from it can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. The value of tax reliefs depends on your individual circumstances. Tax laws can change.
CA6806 Exp 05/2022