Reasons to contribute over the lifetime allowance
The lifetime allowance (LTA) is set to increase from next April for the first time since 2010. Given the hatchet that has been taken to the LTA since then, this is a welcome change in direction. The plan to increase the LTA in line with the Consumer Price Index (CPI) was announced in 2015, and confirmed by the Treasury in July this year (although at least one former pension minister has expressed views that it may yet be due for a trim once more come budget time).
The reality is that more and more people are being caught by the LTA, and although any increase in its level is welcomed, the CPI linking will slow the growth of people being caught, rather than change the direction of travel.
So, if you know you are likely to breach the LTA why would you continue to put money into a pension?
Let’s look at the pros and cons.
Those who have LTA issues are likely to be at least higher rate tax payers – may be additional rate.
Assuming higher rate relief going into a pension any personal contributions will benefit from 40% relief. If you have control of your company and pay an employer contribution instead of salary, effectively you get 40% relief plus NI savings on top.
Once in the pension we all know you benefit from tax-free compound growth.
On the downside, once the LTA is breached you’re going to pay a tax charge on the excess, plus income tax on any withdrawals you make.
If you take the excess as income the LTA charge is 25% and then income tax on the balance. For a higher rate tax payer this is an effective rate of tax of 55%. Of course someone who may have been a higher rate tax payer whilst paying in may only be a basic rate tax payer at point of withdrawal, in which case the effective rate of tax is only 40%.
If you choose to take the excess as a lump sum instead of income then the charge is 55%, so really only a viable option for higher or additional rate tax payers.
If you are likely to be a basic rate tax payer in retirement than 40% tax relief going in and 40% tax coming out with the benefit of tax-free growth in between isn’t a bad deal. If you’re still a higher rate tax payer than the 55% tax rate on withdrawal looks high, but you need to weigh up the benefit of those tax-free compound returns versus taxes paid if invested elsewhere over the same period.
The real benefit may come if you don’t need the pension above the LTA, but are instead looking at tax-efficient ways of passing funds to the next generation. If the pension is untouched on death before 75 then the 25% lifetime allowance charge will apply to the excess, and the balance can be paid tax-free to any nominated beneficiaries provided designated within two years.
Taking the more optimistic view that you live beyond age 75, then the 25% lifetime allowance charge will be taken on your 75th birthday, with growth thereafter exempt from any further test. Income tax will be payable when your beneficiaries eventually withdraw the funds, but this will be at their marginal rate, not yours. By this stage of life you may well have grandchildren, as well as children, and potentially great-grandchildren. You can have any number of beneficiaries, and passing funds on to non-taxpayers is especially efficient. Beneficiaries under the age of 18 would effectively have their funds managed by parents and could be used for school fees or the like.
Another option if you don’t need the excess funds personally is to take income and use it to fund pension contributions for your children. By the time you reach later life your children could well be higher rate tax payers, so withdrawals at an effective rate of tax of 40% could be used to fund their pension contributions in a tax neutral way. Doing this moves funds from a scheme with a LTA excess, to the next generation who may not have the luxury of the same issue.