Lifetime allowance – don’t let the tax tail wag the dog

Nobody likes the idea of paying more tax. So it was perhaps unsurprising to see headlines referring to the freeze in the lifetime allowance (LTA) in this March’s Budget as a “tax raid on pensions”. Alongside the freeze in the Income Tax allowances and bands from 2021/22 onwards, it was probably the biggest announcement in terms of personal finance.

At the time, we all dusted off the phrase ‘fiscal drag’ and eventually moved on.

Recently though, there have been an increasing number of articles published with tips and investment strategies around how to ‘avoid the LTA’ or associated tax charges both at retirement and at age 75. There are also tales of increasing numbers of early retirements from the public sector as the LTA is viewed as a deterrent.

Different people will have different objectives and many factors are at play in retirement decisions – however, I struggle to understand why deliberately switching investment strategies so that the underlying pension fund stops or slows in its growth would ever be a worthwhile endeavour.

The LTA isn’t a hard limit – it is a check point, where funds in excess of the value of the allowance might be subject to a tax charge. Pension funds are initially tested against the LTA each time the client brings funds into payment (crystallisation). Any funds left uncrystallised will be tested against the LTA at the client’s 75th birthday or, if earlier, at their death. There is also assessment of funds already in drawdown at age 75, with any investment growth in excess of the rate of income withdrawal and charges being tested.

In a client’s lifetime, any tax payable is deducted from the pension funds themselves, rather than coming directly from the pocket of the client. The LTA excess charge is at a rate of 25% if the funds remain inside the pension wrapper (where they might be subject to Income Tax once withdrawn at a later date) or 55% on any excess taken as a lump sum before age 75.

The last decade has largely seen the allowance frozen or cut from its previous high of £1.8 million in 2010, which has brought it into orbit for many more clients and investors than it would have previously. Whilst I can empathise with those who view it as a tax on investment growth, I find myself in agreement with one adviser in particular – Alistair Cunningham – who said on Twitter that he viewed the LTA as a “target and not a limit” and that “… for many people, avoiding the LTA charge at 25% is as foolish as worrying a promotion might make you pay 40% Income Tax not 20%”.

There are other powerful reasons to keep on saving within pensions. I haven’t even talked about tax relief on contributions to pensions (although they are subject to their own annual allowances) and the generous tax treatment of pensions on death of the member, potentially allowing pension wealth to cascade down the generations if unspent, free of Inheritance Tax in all but a handful of cases.

One size does not fit all in terms of retirement planning strategies. It would be boring if that was the case. One thing is sure, though: the best financial advisers and planners will be relishing the opportunity to demonstrate the value they can add in the retirement planning journey for clients and their families and distancing themselves from the unhelpful and at times misleading headlines many of those clients will be subject to.

This article was previously published by FT Adviser