As time goes on, it’s becoming clearer how firmly the lifetime allowance has sunk its teeth into private pensions wealth in the UK.
The level of the lifetime allowance has been on a rollercoaster since being introduced in 2006; first rising to the heady heights of £1.8 million, before falling to a low of £1 million. It’s now on a slow drag upwards, having reached £1,073,100 in 2020/21, and should increase each year in line with CPI.
But as pension wealth increases at a faster rate, more people are having to organise their pension affairs to negotiate a possible lifetime allowance charge.
This doesn’t just affect a niche group. Figures from HMRC (published September 2019) show a sharp increase in both the number of lifetime allowance charges paid and the total value of those charges. Paying a lifetime allowance is no longer an unusual occurrence or the preserve of the super wealthy.
This article explores further the issues people need to consider when planning around a potential lifetime allowance charge and runs through a case study to demonstrate how some of these could play out in practice.
Pension planning – the basics
The lifetime allowance represents the amount of money that can be taken from pensions before the lifetime allowance charge applies. The amount of pension benefit is tested against the lifetime allowance at a benefit crystallisation event (BCE). A charge will be applied to any excess over the lifetime allowance. The charge is 55% if the excess is taken as a lump sum, and 25% if the excess is retained within the pension pot (the theory being that when the money is taken as an income, 40% Income Tax will apply, making an effective total tax rate of 55% for higher rate taxpayers).
There are 13 BCEs. It’s worth pulling out a few key ones. Pension values are tested against the lifetime allowance when benefits are first taken as drawdown, a lump sum, an annuity, or a scheme pension. Uncrystallised benefits are tested at age 75. But there is also a second test on drawdown benefits at age 75 which measures the investment growth on the funds while in drawdown against the lifetime allowance.
If the member dies before crystallising benefits and before age 75, then the benefits are tested against the lifetime allowance. If the member has previously designated drawdown and dies before age 75 (and the second drawdown test), there is no further BCE.
Another pension tax rule affecting people’s planning decisions involves the Income Tax paid by beneficiaries of death benefits. If the member dies before age 75, then no Income Tax is paid. If they die after age 75, then Income Tax is due on pension benefits taken by the beneficiary.
Approaching lifetime allowance – crystallise or not?
If your client has pension funds that are more than their available lifetime allowance, then they will have to decide what strategy to adopt. They could decide to crystallise all their pension funds before 75. Alternatively, they could only crystallise funds up to 100% of their lifetime allowance and designate these to drawdown, leaving the remainder – the excess – uncrystallised.
If they choose this second route, they will then have to decide how to manage the second drawdown BCE at age 75. Should they take out an income which will allow them to always maintain the same drawdown fund value as the day they crystallised, and so avoid a lifetime allowance charge?
Or, in either case, should they just enjoy full investment growth, and resign themselves to paying a lifetime allowance charge at age 75? After all, they get to benefit from higher funds and paying a Government charge may not be the worse outcome.
There is no right or wrong answer. It depends upon the specific circumstances, and beliefs, of the client. There are, however, several key points to consider when pension planning to avoid or reduce a lifetime allowance charge.
- How likely is the member to live to age 75? Reaching age 75 is a key date in pension planning terms – a second drawdown BCE arises and Income Tax is due on the beneficiary’s benefits. Most people celebrate their 75th birthday – only a third of the half a million people who die in England each year are younger than 75*. But if they do expect to die early, they may want to crystallise immediately as there won’t be a further BCE on death, and their beneficiaries can enjoy the full value of any investment growth on the fund between crystallisation and death.
- Tax rate on withdrawals – how much tax would someone pay if they took benefits out of the pension plan, possibly to avoid a lifetime allowance charge?
- Gifting money – if the member took money out of the pension plan, would it sit within their estate or are they able to gift the money to others, bearing in mind the current Inheritance Tax (IHT) rules and allowances?
- Potential beneficiaries – if the member has no need for the pension fund money, then they may want to leave it within the pension plan for the next generation. In that case, who are the nominated beneficiaries and what rate of Income Tax will they pay? Do they need the money now or can they wait until the member dies to receive the benefits?
- Other sources of income – what other investment or earned income is the member receiving? And how does this affect the level of tax they pay and the income they may need – or not need – from the pension plan?
Case study – Emily
Emily is 60. She is stopping work and has built up a SIPP fund of £1,273,100. She has no lifetime allowance protection. She also has other sources of income. But she wants to access her pension to realise the pension commencement lump sum (PCLS) to gift to her children to help them buy a house.
Emily decides to designate up to her lifetime allowance – £1,073,100 – into drawdown and take the maximum PCLS of £268,275. The remaining drawdown fund is £804,825. Her lifetime allowance is now fully used up. However, she still has £200,000 uncrystallised.
Should she leave this fund uncrystallised, or designate it to drawdown now and draw down an income to reduce any lifetime allowance charges at age 75?
Option 1 – fully crystallise
Emily decides to fully crystallise her whole pension fund.
She pays a lifetime allowance charge of £50,000 on her excess funds of £200,000, leaving her a drawdown fund of £954,825 (£804,825 + £150,000).
If, at age 75, she wants to have the same drawdown fund as she does now (at age 60) – and so avoid a lifetime allowance charge at the second drawdown crystallisation event – she will need to withdraw income. If she made a withdrawal of £38,193 a year, she could avoid a future lifetime allowance charge (assuming 4% a year net growth over 15 years).
At age 75, her drawdown fund is still worth £954,825. Plus she has withdrawn 15 years’ worth of £38,193, which is £572,895. Adding that to her drawdown fund gives a total of £1,527,720.
Option 2 – leave the excess uncrystallised
An alternative strategy is to leave her excess of £200,000 uncrystallised, and not to take any income from the pension fund.
At age 75, and assuming a growth rate of 4% net of charges, her drawdown fund is £1,449,000 and her uncrystallised fund is £360,000. Emily will have to face two BCEs and pay two lots of lifetime allowance charges.
BCE 5A tests the investment growth on the drawdown fund. This is £1,449,000 – £804,825 = £644,175. The lifetime allowance charge is 25% of £644,175 = £161,044. This leaves a drawdown fund of £1,449,000 – £161,044 = £1,287,956.
BCE 5B tests the uncrystallised funds at age 75. The lifetime allowance charge is £90,000 (25% of £360,000). Once deducted, this leaves an uncrystallised fund of £270,000.
Her total pension funds are £1,287,956 + £270,000 = £1,557,956.
Which option should she choose?
Both options give broadly similar answers. However, I have used a simplified case study. For example, I haven’t made any deductions for Income Tax, which may lower the value of option 1, if Emily is a higher rate tax payer but wants to maximise the funds to pass onto her children or grandchildren who are basic rate or non-taxpayers.
Taking income may also create IHT problems if the money sits within her estate, and Emily may want to shield the money within the pension.
I am assuming she is in good health, but if she is likely to dies before 75, then that may change her approach to crystallising the whole fund. Instead, she may want to designate it all to drawdown and enjoy the full investment growth on the drawdown fund without any further lifetime allowance charge.
And I have only briefly explored two options – there are others available to Emily. She could decide not to crystallise any funds at all or to phase her crystallised benefits over the 15-year period.
These are complicated decisions. Each of your client’s circumstances will be different and personal to them. As will be their objectives and wishes.
There are many factors to consider, and there is not necessarily a right or wrong answer. Many clients want to take every action possible to avoid paying a lifetime allowance charge, but in the end that may be a necessary fallout from building up pension funds, and therefore not the worst outcome.
*Public Heath England, 14 June 2019: Death in people aged 75 years and older in England in 2017.
This article was previously published by FT Adviser
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