The lifetime allowance charges explained

Pension benefits are tested against the lifetime allowance whenever a benefit crystallisation event (BCE) occurs. If the value of the benefits tested exceeds the member’s available lifetime allowance, a tax charge is due on the excess.

Often, we are more focused on preventing a lifetime allowance charge than managing one. Where prevention isn’t possible or practical, careful planning is invaluable in mitigating the impact the charge has on your client’s pension and their overarching goals. Understanding how the charge is calculated and paid is the first step.

How is the charge calculated?

The charge is calculated at one of two rates. The rate used depends on how the excess is dealt with; either 55% if paid as a lifetime allowance excess lump sum, or 25% if retained within the scheme.

The charge arises when the BCE occurs, so no further lifetime allowance charge applies when income is drawn. The different rates reflect that future withdrawals are expected to be subject to Income Tax at the member’s marginal rate, whereas the excess lump sum is not.

Your client may not always have a choice in how the excess is dealt with. For example, any excess when transferring to a QROPS (BCE 8) and when reaching age 75 (BCEs 5, 5A and 5B) will always be a retained amount. Sometimes a scheme’s rules will stipulate what options are available, so this should be checked as well.

How is the charge paid?

During life, the member and scheme administrator are jointly and severally liable for paying the charge. In practice, the scheme administrator must make the payment and the member’s benefits will usually be reduced to reflect this.

Defined contribution (DC) schemes achieve this by deducting the monetary value of the charge directly from the excess amount. Defined benefits (DB) schemes instead need to complete an actuarial calculation to determine how much to reduce the annual scheme pension by. This varies scheme by scheme, so contact the scheme to understand how your client will be impacted.

Importantly, the charge must be paid from the scheme it arose in. If your client has more than one pension, the order in which they come into payment can be an important planning opportunity. It may be preferable to pay the charge from a DC scheme, rather than from a DB scheme where guaranteed pension rights could lose value. If there are multiple BCEs on the 75th birthday the member can choose the order in which they are tested.

After death, liability for paying the charge falls solely on the beneficiaries. Where there is more than one beneficiary, liability for the charge is apportioned on a ‘just and reasonable’ basis, which in practice means it is split proportionately.

The positive side to this is that the beneficiary can choose what funds they use to pay the charge. This flexibility, which isn’t available during the member’s lifetime, could allow the beneficiary to continue to benefit from the tax-efficiencies of the pension wrapper, whilst reducing their own future Inheritance Tax liabilities by paying the charge directly from other funds they have available instead of the inherited pension benefits.

This article was previously published by Professional Adviser.