Why advisers need to be aware of the second LTA test

When I go and speak to fellow professionals and explain it to them, it is incredible how frequently I am met by surprise, followed by panic.

If you heard your clients could be landed with a tax bill of tens of thousands of pounds from HM Revenue & Customs (HMRC) when they turn 75, you would be nervous too - and would likely put measures in place to prevent it from happening and from jeopardising your ongoing relationship, as well as any future legacy business.

The reality is, this is something that is going to be affecting more and more people in the coming years, with a lot of money and reputational damage potentially at stake.

When pension freedoms were announced, I can guarantee that financial advisers weren’t thinking about the effect it would have on the second LTA at 75.

Financial advisers must bear in mind the unwitting risks of falling foul of the second LTA.

Post-pension freedoms, advisers started to recommend leaving the pension alone for as long as possible and drawing income from other sources due to the fact death benefits can be passed down to beneficiaries tax-free if the client dies before age 75. This flipped holistic financial planning on its head overnight and has now brought the second LTA into the spotlight.

The key thing to remember is that it will affect those people approaching retirement age whose pension is not going to be their biggest asset.

The benefit of leaving a large pension pot untouched to then be accessed tax-free, either at a later stage or as an inheritance, is obviously appealing, and if you are lucky enough to be in a position where other income streams can maintain your lifestyle through your retirement, then this makes a lot of sense.

However, financial advisers must bear in mind the unwitting risks of falling foul of the second LTA.

What is the second lifetime allowance test?

When the LTA was brought into place all those years ago, HMRC made sure of two things at age 75:

1.    You have to test any uncrystallised benefits; and

2.    You have to test any growth on already crystallised funds i.e. drawdown funds - the second LTA is on these funds.

Example

If you crystallised £400,000 in 2015, you would have created £100,000 tax-free cash. £300,000 would have been moved into drawdown, from which income can then be drawn - and would be subject to income tax. 

Let’s then say that in 2017 you crystallised another £600,000, creating £150,000 tax-free cash and £450,000 was moved to drawdown. 

In total, this means £250,000 has been taken tax-free as a lump sum and £750,000 has been moved into drawdown. With the lifetime allowance currently at just over £1m, this means that you have nearly used up your LTA.

However, a healthy combination of Isas, general investment accounts, rental income from property and also the tax-free cash that has been created is more than sufficient to live off, so you decide not to touch the pension for the time being.

By 2025, this pot will hopefully have grown from £750,000 to somewhere in the region of £900,000, and this is where the second LTA can wreak havoc on any best-laid plans.

The drawdown pot has grown by £150,000, which will have to be tested against the current lifetime allowance. In this example, you have already used almost all of your LTA, meaning the majority of this growth is no longer tax-free. In fact, it is taxed harshly at 55 per cent, so you could face an eye-watering bill of around £80,000 - a horrible surprise for anyone. 

What changed after the pension freedoms?

One of the huge benefits since pension freedoms is that pensions can be passed down to beneficiaries free of tax before 75 and can keep being passed down to successors after that, making a pension a great way to protect clients against taxes on death. 

Leaving the pension alone and drawing income from other sources for as long as possible is a great inheritance tax (IHT) planning tool but can cause client issues at age 75 if the client has LTA problems and allows their drawdown fund to grow.

Once all of a pension has been crystallised, we would hope we could forget about the dreaded LTA but this is very much not the case, and the penalties are worth considering.

Now that the LTA is down at a measly £1,030,000, more and more clients in the very near future will be affected by the LTA, and the age 75 test should become even more prevalent in retirement planning. 

I’m not saying you should avoid paying an LTA charge at all costs, as there are lots of things to consider, but this is definitely something you should be aware of.

The rules are essentially in place to try to encourage people to take income from drawdown, even if it is just at the same amount as the interest the pension will be accruing every year.

Of course, any withdrawal from drawdown will face income tax, likely to be in the top band at 40 per cent. This could still then be gifted to any beneficiaries as a means of protecting them from IHT, but is lessened by being removed from the pot.

While a full drawdown pot can be passed down without facing IHT, the calculation is whether the tax on its growth before the second LTA at 75 - either 55 per cent if you remove the excess as a lump sum or 25 per cent if you move it into drawdown - is still more cost-effective than withdrawing, say, 5 per cent every year from drawdown and paying income tax on it.

Ultimately, it is a nice problem to have to be comfortable enough to be able to make these considerations.

However, it is well worth factoring into any ongoing retirement plans because, as previously mentioned, it still seems to be taking far too many financial advisers by surprise, and is only likely to become more commonplace in the coming years.

Matthew Rankine is sales director at Liberty Sipp