Tax Doctor: Why for some it makes sense to exceed the lifetime allowance
Kirk has surplus funds he wants to invest. He has already used up his lifetime allowance (LTA), but he decides to contribute those funds to a pension.
Several years ago, Kirk left his job as a senior manager in a high street bank and has been focusing on his hobby of selling TV sci-fi memorabilia online. While this was a leap into uncharted territory for him, he has been making sizeable profits now for several years.
Kirk has a Defined Benefits pension scheme from his time at the bank, and he started taking benefits from it when he left employment. This used up almost all of his LTA.
Kirk’s DB pension is enough to cover his day-to-day expenditure, and he is now thinking about what to do with the money he is making from his business.
He has two children who are basic rate tax payers and five young grandchildren. Kirk himself is currently a higher rate tax payer.
He knows he is very close to the LTA thanks to his DB scheme, but he’s made the discovery that it may still be worth contributing the funds to a pension.
If Kirk puts the funds into a pension, he will eventually pay an LTA charge of 25 per cent on those funds. This is unavoidable and will happen either when he takes benefits, when he turns 75 or when he dies.
He will also pay Income Tax on any withdrawals he makes. However, he will still be able to take his 25 per cent tax-free lump sum.
A worthy enterprise
As Kirk is a higher rate tax payer, he will get tax relief of up to 40 per cent on the contributions.
If he later comes to take income from his pension, he will have paid a 25 per cent LTA tax charge. If he is a basic rate tax payer at this point, the effective overall rate of tax for any income he withdraws, however, is also 40 per cent.
Crunching the data, this means he’ll have gained 40 per cent on the way in and he’ll lose 40 per cent on the way out. This doesn’t seem too bad on paper, particularly as his pension will benefit from tax-free compound growth.
He could achieve a similar effect with an ISA. The advantage with a pension, however, is that it will not form part of his estate, meaning it won’t be subject to Inheritance Tax when he dies.
The next generation
Talking of death benefits, Kirk is also conscious that he might not need to withdraw any income from his pension at all, instead leaving it to his children and grandchildren when he passes away.
If Kirk dies before he turns 75, there will be a 25 per cent tax charge when the death benefits are converted to dependants’ or nominees’ drawdown. However, the recipients would be able to withdraw the funds tax-free.
If Kirk manages to cling on beyond 75, there will be a 25 per cent LTA tax charge at age 75, and the death benefits would be taxable in the hands of the recipients.
Even then, however, his children are basic rate tax payers and his grandchildren don’t currently pay any tax at all. Each has their own Income Tax personal allowance, so there is scope to manage withdrawals in order to minimise the tax that each one pays.
As such, both of these scenarios still look favourable given the 40 per cent tax relief on the way in. Therefore, despite the LTA tax charge, Kirk decides to boldly go ahead with making the contributions to his pension.