Lifetime allowance planning

We often get asked if it is better for a client with lifetime allowance (LTA) issues to strip out funds before age 75 to mitigate the tax charges at that age, or to leave funds invested?

The answer as always is that it depends on individual circumstances, but the case study below aims to illustrate the effect of two different approaches.

Many of you will use cash-flow planning to analyse individual cases as well as presenting your recommended option, but what is going on behind the scenes?

Case study – Mrs Goulden

Mrs Goulden, is age 60 and looking to retire. She has built up a fund of £1,230,000 in her SIPP, and she and her partner also have other sources of income they will be able to draw upon in retirement.

In the short term, she would like to use any available tax-free lump sum (PCLS) to help her adult children get onto the property ladder, but she is aware her fund is over the current LTA and would like to know the likely tax charges and how she might be able to mitigate them.

Assuming she has no lifetime allowance protection, what would happen at age 75 if she left her fund after PCLS invested vs taking withdrawals now?

Leave it alone?

If Mrs Goulden crystallises her SIPP up to the LTA now, her maximum tax-free lump sum would be £263,750, and £791,250 would be placed into drawdown initially. The remaining £175,000 over her LTA would remain uncrystallised for now. She would have used 100% of her LTA.

Fast-forward to age 75 and there would be two benefit crystallisation events (BCEs): one on the remaining uncrystallised funds, and one on the growth in the drawdown fund which was left untouched.

Assuming a growth rate of 4% pa (net of charges), the fund would now be worth £1,740,160. After deducting the original amount placed into drawdown, the 25% LTA excess tax charge following both BCEs would be £237,227.50, leaving a fund value of £1,502,930 at age 75.

Drawing an income

What would be the position if Mrs Goulden withdrew income from the pot to mitigate the LTA charge at age 75?

Assuming she crystallised everything at outset, then alongside her PCLS of £263,750, an amount of £922,500 would be designated to drawdown after an immediate 25% tax on the LTA excess of £175,000.

In order to avoid an LTA charge at age 75, she would need to drawdown £35,500 pa over the next 15 years. This assumes a net investment growth rate of 4%. With other sources of income (and especially when the state pension kicks in) some of this income will be charged at 40%.

The fund value at age 75 would be £922,100, and £106,500 would have been paid out as income (subject to income tax) over the 15 years.

Although her income needs are largely taken care of elsewhere, Mrs Goulden could put this pension income to work, assuming she would like to pass some of it on.

The income could be used to fund pension contributions for her children (and any grandchildren). They would benefit from the gift as any tax relief due based on their earnings. It would be prudent to make these gifts on a regular basis and keep records as evidence to ensure the exemption from IHT (out of normal expenditure) is met. Available annual allowance would need considering for the recipients.

Other factors

What else might influence which option (or mix of options) you might recommend? There is of course the generous death benefits regime to consider and the fact that pensions are normally out of scope of IHT.

On death pre-age 75, any uncrystallised element (plus some growth) in our first scenario would face an LTA excess charge, although any tax due on death is not deducted by the provider, as is the case with BCEs that occur in the member’s lifetime. Any withdrawals by the beneficiaries would be free of income tax if the funds are designated within two years.

If Mrs Goulden passed away after age 75, there would no further LTA assessment and the withdrawals would be subject to tax at her beneficiaries’ marginal rate. If these are her children and even grandchildren, then they may pay tax at a lower rate than Mrs Goulden was.

So what have we learned? Despite pensions being a retirement income vehicle, the pension freedoms and death benefit rules mean some people may benefit from meeting their income needs from other sources in their lifetime. Expectations will need to be managed though, as the prospect of a higher one-off tax charge at age 75 is not always palatable, even if it might be the best way of meeting wider planning objectives.

Senior Technical Consultant

Charlene is a Chartered Financial Planner with over 10 years' experience in financial services. She joined AJ Bell in 2014 after relocating to Manchester from Bristol, where she held financial planner and paraplanner roles at leading firms. In addition to analysing and commenting on technical and regulatory issues, Charlene is also responsible for designing and providing technical training for AJ Bell staff.

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