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.
Protection 2014
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:
1. Personal contributions to defined contribution schemes are not efficient if they will fall into the LTA charge when benefits are drawn.
2. Employer contributions to defined contribution schemes that will fall into the LTA charge may or may not be tax-efficient:
• Where there is the potential to renegotiate remuneration with the employer (for example, to take the equivalent of the employer contributions as salary or other benefits in kind), the net benefit of the alternative should be compared against the net benefit of the pension contributions.
• If employer contributions are ‘free’ and there is no alternative on offer it is probably more efficient to continue receiving the contributions. Even where employer contributions are falling directly into the LTA charge, 75 per cent of that contribution is better than no contribution at all.
• If the level of employer contribution is determined by the level of employee contributions, the tax efficiency will depend on the proportions involved because the personal contributions are effectively not attracting tax relief.
3. Defined benefit accrual may be worthwhile even if it is falling straight into the LTA charge. Instead, opting out freezes the salary and number of years’ service used to calculate the starting pension.
Therefore the pension at retirement may be considerably lower than if they had remained an active member and had their starting pension reduced by a LTA charge.
The further the individual is from normal retirement age the more valuable active membership of a final salary scheme is. The increase in benefits in the last few years of a final salary scheme is disproportionately higher than the cost to the individual.
Taking an LTA excess
The decision on whether to draw any LTA excess as a taxed lump sum or as taxable income will depend on the individual’s wider circumstances and objectives.
If the LTA excess is taken as income, the net benefit of withdrawals will be determined by income tax bands. This method is not efficient if the pension income will fall into additional rate tax.
The lump sum option provides flexibility and investment opportunity. If it is used for gifting it will generally be removed from the estate after seven years. However, if the lump sum is not spent but simply accumulates in the estate (or any gifts fail), the impact of IHT makes the lump-sum option less tax efficient than if the LTA excess had simply been left in the pension.
For any funds remaining in drawdown at death, any death benefit lump sum will be subject to a 55 per cent charge. If there is a requirement for a dependant’s pension, the death benefit lump sum tax point will be after second death, by which time more income should have been drawn.
The case study below gives an example of what can happen by crystallising or moving taking an excess as a taxed lump sum.
| Case study |
Harry crystallises his pension and has a lifetime allowance excess of £100,000. This amount is surplus to requirements and he intends for it to ultimately benefit his daughter. If he takes it as a taxed lump sum, he will receive £45,000 net. He gifts this to his daughter. • If he survives seven years from the gift it is successfully out of the estate. • If he dies beforehand, while there is no direct tax on this gift it will effectively push £45,000 of his death estate into IHT at 40 per cent. The net benefit of the gift could therefore be as low as £27,000. If instead he had opted to move the lifetime allowance excess into drawdown, the net receipt into drawdown would be £75,000. If this sum was untouched on his death, the pension scheme could then pay a taxed lump sum to his beneficiaries less the 55 per cent death benefit charge. The net legacy would be £33,750. |
From age 75 any LTA excess cannot be drawn as a taxed lump sum; it must be taken as income.
Victoria Harman is technical support consultant at Hargreaves Landsdown
