Any pension benefits drawn above an individual’s available lifetime allowance (LTA) will be subject to the LTA charge. However, this charge should not be avoided at all costs. It is important to look at the net benefit throughout retirement, not just the one-off charge at the point of taking pension benefits.
Lifetime allowance charge
Where any LTA excess is taken as income (such as through drawdown, an annuity or a defined benefit pension), 25 per cent of that excess is paid to HMRC by the scheme at the point of crystallisation.
The remaining 75 per cent is available to pay income and subject to income tax as normal.
An LTA excess taken as a lump sum is immediately taxed at 55 per cent. This rate is intended to be broadly equivalent to the total tax taken from income payments assuming the individual is a higher rate taxpayer, so a 25 per cent LTA charge followed by a 40 per cent income tax charge on the remainder leaves the individual with 45 per cent of the original sum.
The headline rate of 55 per cent may appear substantial but it must be remembered that if these benefits had fallen within the LTA, they would still have been subject to income tax when drawn from the pension.
With the impending reduction in the standard LTA on 6 April 2014, HMRC has introduced two protections.
‘Fixed protection 2014’ will work in the same way as fixed protection 2012 except that the individual’s LTA will be fixed at £1.5m. No benefit accrual is permitted after 5 April 2014 and applications must be with HMRC by that date.
‘Individual protection’ will allow contributions to be made after 5 April 2014 without the loss of protection. It will be available where pension benefits are valued at £1.25m or more on 5 April 2014 and provides an individual LTA of the value at that date capped at £1.5m.
Individual protection will shelter the fund value as at 5 April 2014. This means that only growth and further contributions/accrual after that date are subject to the LTA charge. Where the pension value lies under £1.5m, contributions could be brought forward to before 5 April 2014 in order to maximise the level of protection.
If an individual is eligible for individual protection there is no downside to applying for it, even where they already hold fixed protection. Fixed protection will take precedence where both protections are held.
In the event of pension benefits being lower than the level of individual protection at retirement (for example, due to poor market conditions), a top-up contribution could be made. This will revoke fixed protection and the individual can then fall back onto individual protection.
Any decision to cease pension contributions or accrual in order to apply for fixed protection in 2014 must be carefully considered.
Contributions and accrual
The key to LTA planning is to project the individual’s pension benefits to their normal retirement age. For individuals who are likely to reach or exceed the LTA, whether or not to continue saving into pensions will depend on their particular circumstances.
The tax efficiency of further contributions/accrual is determined by various factors: the net cost of contributions into the pension and income tax, LTA charge and any inheritance tax (IHT) and/or death benefit charges on the way out of the pension. Clearly some assumptions will have to be made here which may not be borne out in practice. However, the following will serve as general rules: