Lifetime allowance drawdown conundrum
With the ever-decreasing lifetime allowance (LTA) comes an increasingly common conundrum – do you advise clients with LTA issues to strip out funds before age 75, or leave them in a pension to pass to the next generation, with a risk of a further LTA hit at 75?
Let’s take the example of Mrs Smith, aged 60 with pension savings currently valued at £1.2m. She has no protection having until her recent retirement been accruing benefits.
Mrs Smith decides to take her maximum PCLS of £250,000 (25% of the LTA) to gift to her two children to help them on to the property ladder. She is in good health so likely to survive 7 years for the gifts to be free of inheritance tax (IHT), but her children are aware of the implications were she to die in this period.
Taking PCLS of £250,000 places £750,000 into drawdown, with £200,000 uncrystallised and all her LTA used up. She has other sources of income so does not need to draw further benefits.
The question then is, is she better leaving funds invested, or drawing down to reduce the LTA charge at age 75?
Let’s look at the drawing down option.
To crystallise the remaining £200,000 fund she would pay a 25% LTA charge immediately, leaving a total of £900,000 invested. At age 75 this is the “credit” she would have against the LTA charge, so any growth would be subject to 25% tax. Let’s assume an average of 5% growth after charges over the 15 years to age 75. That would mean withdrawing £45,000 a year on average to negate a future LTA charge. With other sources of income it is likely that some of this will be taxed at 40%, if not 45%. You may be able to turn off the other sources of income, so the pension income is all within the basic rate band, but you would then need to look at the tax implications for those sources. If income is not needed then gifts out of income can be made to avoid an IHT hit on death. What you don’t want to do is take the income and then leave it in the estate to be liable to IHT as well.
By stripping out the growth as long as the pension is not worth more than £900,000 at age 75 there will be no further LTA charge. On death post age 75 death benefits will be subject to income tax for the beneficiaries, prior to age 75 they will be tax free, with no LTA test.
Alternatively funds could be left invested.
Again assuming 5% growth after charges, the £750,000 drawdown fund and £200,000 uncrystallised fund will be worth around £1,975,000 at age 75. There will be a credit for the £750,000 previously put into drawdown and a 25% LTA charge applied to the difference, so £306,250 charge with £1,668,750 remaining in the pension. If Mrs Smith never needs these funds then they will be distributed on her death post 75 with no further LTA charge, no IHT, but subject to income tax in the hands of the beneficiary. If there are grandchildren, or even great grandchildren, who are none tax payers it is possible to withdraw up to the nil rate band each year with no further charge. For basic rate tax payers, the effective rate of tax is 40% on the funds that have had the LTA charge deducted, for higher rate tax payers it would be 55%.
Every client will be different, but key points to consider when making the decision are:
- Health – is the client likely to reach age 75? Tax rate payable on withdrawals
- Whether they want to gift money in their lifetime
- Who are the potential beneficiaries, and what tax band do they fall into?
- What other sources of income does the client have?
Finally, the basic principle of compound growth in a tax-advantaged environment makes keeping money in the pension attractive, but funds withdrawn and gifted could be used to fund contributions for the next generation who may not have the same LTA issues.