Tax Doctor: age 75 and the lifetime allowance charge

The case

Sally has built up considerable pension benefits through her career. She took her defined benefit scheme at age 65 then, three years later, she took her tax-free cash from her SIPP and designated the remainder into income drawdown. Since then she has enjoyed good investment growth and hasn’t taken any income. She has no lifetime allowance left and no protection.

Sally is now approaching her 75th birthday, when she will face a second crystallisation event. The amount tested against the lifetime allowance is the value of the income drawdown plan now less the value when it was first set up. In other words, the amount of growth in the plan. Any excess is taxed at 25% (never at 55%).

When Sally set up her income drawdown plan it was worth £100,000. Now it’s worth £147,000, a difference of £47,000. A lifetime allowance charge of £11,750 (25% of £47,000) is deducted, leaving £35,250 of the excess in Sally’s SIPP.

Is paying this lifetime allowance charge the most tax-efficient solution?

The prescription – minimise LTA charge

Sally could avoid a lifetime allowance charge by taking out enough drawdown income to reduce her plan to below its original value of £100,000. So she could withdraw £47,000 in the run up to her 75th birthday. Paying 40% income tax on the payment means an income tax charge of £18,800, leaving £28,200 in her pocket.

If Sally needs the money, then the most tax-efficient solution is to take the income payment before the age of 75; otherwise, if she leaves the withdrawal until after that date, she faces both a lifetime allowance charge and an income tax bill.

Sally could also avoid a lifetime allowance charge by switching to a more cautious investment strategy to minimise investment growth.

Taking the hit

Let’s say Sally doesn’t need the income, and instead she wants to pass the excess onto her niece, Chloe, who is aged 56.

If Sally takes the hit and pays the lifetime allowance charge due at the second crystallisation event, this leaves an excess of £35,250 in her SIPP. On her death, the pension plan would normally fall outside the estate for Inheritance Tax (IHT) purposes. If Sally has nominated Chloe on her expression of wish form, Chloe can normally take this pension money either as a lump sum or as a pension income. She pays tax at her highest marginal rate. Or she could just leave it in the beneficiary’s drawdown.

Chloe is a basic rate taxpayer. Therefore the excess amount of £35,250 left in Sally’s SIPP will be taxed at 20% if taken out gradually as income, leaving £28,200. (If she takes a lump sum, then this will push her into a higher tax bracket and some of the lump sum will be taxed at 40%.)

Paying into another pension plan

Another option is for Sally to take the excess out before her 75th birthday, pay income tax, and then pay £28,200 back into Chloe’s pension pot as a third-party contribution. As long as she takes care doing this, she can set up this payment under the IHT normal expenditure rules. Chloe will receive 20% tax relief on the contribution, meaning a gross contribution of £35,250. As she is over 55, she can withdraw this money; 25% will be tax free and the rest be taxed at 20% if taken out gradually. Obviously, if she does this she will miss out on any future tax-free investment growth in the pension.

The best and most tax-efficient route depends on personal circumstances. If Sally needs the money, her best option is withdrawing it before age 75. If she wants to pass it to Chloe, then paying it into Chloe’s pension plan may be the most tax-efficient route.

Senior Technical Consultant

Rachel is a Senior Technical Consultant helping financial advisers and planners understand the changing pensions and savings environment, as well as how new legislation and regulation affects them and their clients. She’s well known within the pensions and savings industry, and regularly speaks at AJ Bell events, alongside writing content and articles for our website.