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Pension Drawdown Testing Against The Lifetime Allowance

13/12/19 Pension Drawdown

If you are lucky enough to have a relatively large pension fund it is important to understand the  Lifetime Allowance (LTA) and the tax implications. This can be a complex subject and the rules depend in part on which pension option you select (drawdown or annuity). To simplify things in this post we only cover testing a pension drawdown fund against the lifetime allowance.

What Is The Lifetime Allowance (LTA)?

The lifetime allowance is set by the government and is a limit on the value of payouts from your pension schemes – whether lump sums or retirement income – that can be made without triggering an extra tax charge.

When is my fund tested against the LTA?

Your pension funds are not continuously tested against the LTA. In most cases, they are only tested when specific events occur. The most common of these is when you start to draw on your pension on your death before age 75 and on attaining age 75.

What Are The Current Limits?

In the current tax year (2019/2020) lifetime allowance (LTA) limit is £1,055,000. Present legislation dictates the LTA limit will rise in line with CPI (consumer price index) each year In the 2019/2020 tax year, the LTA tax charge is the pension holders marginal tax rate (20%, 40% or 45%) plus 25% on any amount over the LTA limit. If you choose to take a lump sum rather than income, lump sums above the limit are taxed at 55 percent rate.

The LTA In Action - An Example

As an example, assume Mr A has a pension valued at £1,305,000. This is his only pension arrangement and he has contributed to it continuously up to his retirement date. Mr A decides to retire using income drawdown taking benefits from all of his pension (a BCE – Discussed below). His fund exceeds the LTA by £250,000.

On entering drawdown no LTA tax is payable on £1,055,000. However, tax will be payable on £250,000 (the amount in excess of the LTA) dependant on how the individual intends to take his benefits.

If the £250,000 is taken into drawdown to provide a pension income it is taxed at 25% (leaving £187,500 to go into a drawdown fund), with tax at Mr A’s marginal rate of tax on any income that he takes.

If the £250,000 is taken as a cash lump sum it will be taxed at 55% (£250,000 - £137,500) giving him a net lump sum of £112,500.

Drawdown And LTA Trigger Events

Benefit Crystallisation Events (BCE’s) are defined and administered by HMRC. They include taking a pension fund into drawdown, purchasing an annuity or taking a pension lump sum. There are many classifications of BCE’s, each relating to a specific event.

As each BCE occurs a test is made against the Lifetime Allowance to determine if an additional tax charge is due. 

The LTA At Age 75

As highlighted earlier, there are a number of occasions when a drawdown pension is tested against the LTA. When you first access benefits, on death before age 75 or on attaining 75.

The calculation can be fairly complicated but put simply taxable sum is the difference between the amount in the drawdown fund at age 75 and the amount originally taken into drawdown measured against the current (at age 75) lifetime allowance. Obviously, if the amount remaining in drawdown is lower than the original sum no LTA charge applies.

If the amount in the drawdown pension fund has grown it is tested against any remaining LTA. A 25% tax charge applies to any excess.

As an example let’s assume an individual has a pension fund of £900,000 at age 62. They decide to take 10% as a tax free sum and transfer the balance (£810,000) into a drawdown arrangement At this point no LTA charge applies.

They retire at age 63 but their former employer retains them as a part time consultant so withdrawals from their drawdown fund are lower than expected. When they reach age 75 their drawdown fund has grown to £1,100,000. A 25% LTA tax charge will apply on £45,000 (the amount over the value of the LTA limit). The tax payable will, therefore, be £11,250.

What Action Can You Take

There are a number of ways to protect your pension savings from the Lifetime Allowance (known as fixed or individual protection) but it is a complex area of tax regulation and it is important to take professional advice. A wrong move can be costly and there is the added risk of a significant fine from the tax authorities if the procedure is not followed and the appropriate declarations made at the specified time.

Tax regulations are complex and the above is a much simplified overview. If you have a quick question give us a call or use our Chat facility. Given the complexity of the issues involved, it may be best to arrange a call back at a time that is suitable for you. That will give us the time to talk through your individual circumstances in detail.

 

This blog is intended to provide a general review of certain topics and its purpose is to inform but NOT to recommend or support any specific investment or course of action. The past is not a guide to future performance. The value of investments can go down as well as up and you may not get back the full amount you invested. Tax and financial regulations can change. Any figures quoted above are correct at the date of publication.