Pension Lifetime Allowance

Pension Lifetime Allowance

Are you trying to get your head around the pension lifetime allowance?

It’s a complicated topic, however, we are sure the below information will help.

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    The Basics

    Each UK tax payer can save a maximum of £1,073,100 (20/21 tax year) into their pension during their lifetime. This amount has been index-linked to CPI since 2018 and is re-assessed on the 5th of April in each new tax year.

    Should your pension value exceed this amount, there could be a hefty tax of 55% to pay when you come to use the funds in retirement. It is important to understand how and when your pension is tested against the lifetime allowance.

    Uncrystallised or Crystallised?

    When you are paying into your pension, the funds status is classed as “uncrystallised”. When the pension is classified in this way it will not be tested against the lifetime allowance until you reach age 75. This means that even if the value increases above the lifetime allowance, no tax will be due as the funds are still uncrystallised.

    Should you decide to take the tax-free cash or place the pension into drawdown, these events would mean the pension is reclassified as “crystallised”. At this point, the pension would be tested against the lifetime allowance.

    The test is carried out by adding all of the pensions you hold, including any tax-free cash that may have been taken in the past, to create a total pension value. This is then measured against the pension lifetime allowance and any excess will be taxed in one of two ways:

    1. You can withdraw the excess as a lump sum and pay 55% tax.
    2. You can leave the excess in the pension to be used to generate income for your retirement, and in this case a lower 25% tax would be applied.

    It is important to note that you don’t need to test the full value of the pension against the lifetime allowance at the same time. You can choose how much is tested and this creates the chance to delay any lifetime allowance charge should you wish to.

    For example, if you have a pension of £1.2 million and want to start taking benefits from it, you could opt to enter just the £1,055,000 into drawdown rather than the full £1.2 million. This would mean no lifetime allowance would be due, as you have only crystallised up to the lifetime allowance limit. The remainder can be delayed until you reach age 75.

    Age 75 test – As a long stop, all pensions will be tested against the lifetime allowance once you reach age 75. This stops you delaying the lifetime allowance charge indefinitely.

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    Lifetime Allowance Protection

    There are two forms of pension lifetime allowance protection that are designed to help you when it comes to the pension lifetime allowance.

    Individual Protection

    This type of protection allowed you to protect the value of your pension at the point the lifetime allowance was reduced. This last happened in 2016 when the allowance was reduced from £1.25 million to just £1 million. If your pension exceeded the £1 million at this point, you could have applied for individual protection to protect your pension against the new lower rate of £1 million.

    For example, if your pension value was £1.2 million on April 5th 2016 and you applied for individual protection, your lifetime allowance would be fixed at £1.2 million. It is possible to backdate the application. However, the value on April 5th 2016 would still need to be used. You cannot use today’s value and apply for individual protection in 2016.

    Fixed Protection

    This type of protection allowed you to lock in the current value of the LTA before it went down so that your pension funds could grow to this amount in the future.

    For example, if your fund was worth £800,000 on April 5th 2016 you could apply for fixed protection of £1.25 million. This would allow your pension to grow to the higher amount of £1.25 million in the future.

    There is one caveat though. Your pension cannot receive any further contributions from either you or your employer from the date of the protection, in this case, April 5th 2016. If the pension does receive a further contribution it would void the protection and you would default back to the standard lifetime allowance.

    As with individual protection it can be backdated. But you need to be sure that the pension has not received any contributions since the date of the post-dated protection application.

    Applying for protection is relatively easy. By following the link below, you will be taken to a government online portal where you can apply online. Your protection certificate will be sent to you via email.

    For further help understanding if pension protection might be right for you feel free to contact a member of our lifetime allowance protection team and we will be happy to help.

    Calculating your Lifetime Allowance

    To calculate your lifetime allowance, you need to add together the value of all your pensions and any tax-free cash you may have taken over the years. This will give you a final amount and this is your pension’s lifetime allowance value.

    You do not need to add back any income drawdowns you may have taken over the years as these are not counted towards your lifetime allowance. This is because you will have already paid income tax on the income when you withdrew it from the pension.

    This results in a lifetime allowance value of £100,000.

    If your pension commenced payment after April 6th 2006, you multiply the pension by just 20. For example: if you receive £4,000 a year from your DB pension, you will need to multiply this by 20.

    £4,000 x 20 = £80,000

    This results in a lifetime allowance value of £80,000.

    In both cases, this value would be added to any SIPP or defined contribution pensions you might have, and this would form the lifetime allowance valuation.

    Limiting your Lifetime Allowance charge

    When approaching the lifetime allowance limit, one option is to crystallise the pension completely so that it is tested against the pension lifetime allowance before it exceeds it.

    The advantage here is that as your pension has not yet exceeded the LTA, there would be no tax to pay. It would also mean that your pension would be reclassified from, uncrystallised to crystallised.

    This then results in any further investment growth from that day on being classed as “crystallised growth”. It provides some more tax-efficient options than leaving the fund as uncrystallised pension that is exceeding the LTA.

    Crystallised growth that builds up can be withdrawn from the pension as income and would be subject to income tax at one of the 20%, 40% or 45% rates. This would still be much cheaper than the 55% LTA tax that would have otherwise been due on the LTA excess in the future.

    Another advantage is that you can control the flow of income according to other income in the same tax year. You may decide not to take any income for several years and then start to take some in the future. The choice would be yours.

    As long as when you reach age 75, the value of the pension is the same as the value that you originally crystallised, there will be no lifetime allowance excess to pay in the future.

    If you have not withdrawn the crystallised growth before age 75 it will be reclassified as ‘uncrystallised’. It will be taxed as excess lifetime allowance and the charge of 55% may apply.

    The legislation in regard to this is very complex and hard to understand, even for most IFAs. If you have more questions on this topic feel free to call a member of our lifetime allowance team who will be happy to help.

    Lifetime Allowance Strategies

    There are several strategies that can limit the lifetime allowance that you may need to pay in the future. As with all financial planning, the personal circumstances of each person will dictate the best solution. Below you will find a few strategies that might work in your circumstances:

    Crystallise the pension before you breach the lifetime allowance

    If the pension is not needed, you may not think crystallising the pension is a good idea. However, the change in classification from uncrystallised to crystallised will mean that the investment growth moving forwards will be treated as crystallised growth rather than uncrystallised growth.

    This is an advantage as crystallised growth can be withdrawn as income and subsequently income tax paid. This gives the taxman his cut and the amount you withdraw is then not counted towards any lifetime allowance calculation in the future. As income tax can be paid at either 20%, 40% or 45%, it is always cheaper than withdrawing the funds as excess lifetime allowance and paying the higher charge of 55%.

    As long as the value of the pension at age 75 is the same as at the time you crystallised the fund, there will be no lifetime allowance charge to pay. If the fund has grown in excess of the lifetime allowance and you have not withdrawn the excess as income, it will be classed as uncrystallised and tested against the lifetime allowance. Tax at the higher 55% rate may still be due.

    Take the tax-free cash

    Taking the tax-free cash from your pension, even if you don’t need the cash, can help slow down its growth. The tax-free cash can be invested outside the pension instead. A good use for this could be a cash investment into the stock market with the aim of generating some capital gains returns and making use of the £12,000 annual CGT allowance (19/20 tax year). The cash could also be used to fund annual ISAs, which will in turn yield tax free income and investment growth.

    Delay the lifetime allowance into the future

    This option is not one I recommend but is still a strategy. It is possible to part-crystallise your pension pot. That means if you have a pot of £1.2 million you can opt to only crystallise £1,055,000 (19/20LTA Limit) and leave the excess funds uncrystallised and untested.

    This delays the tax charge until age 75 when a final lifetime allowance test takes place. The fund would have benefited from tax-free growth over that time, the tax could then be paid, and the excess lump sum withdrawn.

    Our research has shown that paying the tax early and then withdrawing the income each year is the preferred model. However, it will depend on other income and the income tax band you are in as to how effective this strategy is.

    As you will see above, there are ways to manage the lifetime allowance. None of them can avoid paying tax on the pension in one form or another. But when we pay it, and at what rate, can be controlled.

    For more information call a member of our lifetime allowance team.

    Ideas for Tax-free cash

    Having a high-value pension is great news. However, any income drawn from it is taxed as income for the pension holder alone. This makes it difficult in some cases to withdraw income in a tax-efficient way without paying higher rate income tax.

    Due to this, it may be a plausible option to take your full tax-free cash from your pension and re-invest it elsewhere to make use of some of your annual tax-free allowances that may be underutilised.

    One of my go-to allowances is the annual capital gains tax allowance. In the tax year of writing, 19/20 tax year, the annual CGT exemption is £12,000 per person. This is higher than the personal allowance for income tax. However, it’s rarely used.

    To make use of this, you could consider taking the maximum tax-free cash from your pension and investing it as a cash holding. This would mean that any investment return would be taxed as capital gains, and as a result use up some or all of your annual CGT exemption. It creates a great additional tax-free income each year.

    If you are married, you could even spread the investment over both you and your partner and make the most of two lots of CGT allowance totalling  £24,000 a year.

    To further increase the tax efficiency of this strategy, you could slowly move some of the cash over to your ISA each year. This would then continue to generate tax-free income and would also create some tax-free investment growth as well.

    Clearly the above strategy would require the underlaying investments to perform in each tax year.

    The final added benefit for someone with a high value pension would be that the pension value would be reduced.  As a result, this would limit the investment growth that would otherwise have exceeded the pension lifetime allowance.

    The downside is that the funds would now form part of your taxable estate for inheritance tax (IHT) purposes, as it would be leaving the shelter of the IHT-free pension wrapper. Therefore, some further IHT planning would be required also.

    Lifetime Allowance Percentage

    The lifetime allowance percentage is the percentage of your pension that has been crystallised and tested against the LTA.

    For example, if you had a £1,055,000 pension and chose to crystallise £527,000 you would have used 50% of your lifetime allowance (based on the 19/20 standard lifetime allowance).

    This would leave 50% left to use in the future. This mechanism is quite interesting as the pension lifetime allowance is set to increase by CPI each year. So in the future, the lifetime allowance will be higher than the current £1,055,000 (19/20). If the lifetime allowance increased to £1.2 million in the future for example, you would have 50% of this higher amount to use, 50% x £1.2 million = £600,000.

    In an environment where the lifetime allowance is increasing, a percentage-based lifetime allowance is a good thing. Should limits start to be reduced again in the future, the system would have the opposite effect.

    How to avoid the pension lifetime allowance

    Pre-planning before you breach the lifetime allowance limit could result in avoiding paying any lifetime allowance tax in the future. In this case income tax may still be paid, but this would be at a lower rate of 20%, 40% or 45%, rather than the lifetime allowance rate of 55%.

    If your pension fund has already exceeded the lifetime allowance, managing the crystallisation process carefully can limit the amount you will need to pay.

    QROPS for Lifetime Allowance Planning

    QROPS, otherwise known as Qualifying Recognised Overseas Pension Schemes, have been around since 2006. As the name suggests, they are an overseas pension scheme that has been set up in such a way that it is deemed as “qualifying” by HMRC.

    They are usually based in tax beneficial regions such as Gibraltar, Malta, Cyprus and other countries with a less aggressive approach to tax in order to attract investment.

    The scheme rules, security of the funds, investment options and cost of administration are all virtually the same as in the UK. Funds are held in designated client accounts that are protected against the country the scheme is registered in and can be invested here in the UK once set up.

    QROPS can be a clever piece of tax planning as the transfer of the funds from a UK pension scheme into a QROPS triggers a “benefit crystallisation event” (BCE). This BCE tests the value of the pension at the time of the transfer against the lifetime allowance and any excess is taxed at the lower rate of 25%.

    Once the tax has been paid and the funds transferred to the QROPS, any further growth is then outside the jurisdiction of HMRC, and any further investment growth is not assessed against the lifetime allowance.

    This can be handy if you are very close to reaching the lifetime allowance, as no tax would be due when the transfer occurs. Then, any further growth would not be assessed for lifetime allowance purposes.

    Even if you have exceeded the lifetime allowance, it is possible to split the pot, transfer the amount equivalent to your protected lifetime allowance to a QROPS and leave the excess in the UK to grow.

    The investment growth on the majority of the funds, the funds inside the QROPS, can then grow tax free. And the funds exceeding the lifetime allowance can be left to grow in the UK until age 75, when a final lifetime allowance assessment is made. In this scenario, the hope would be that the lifetime allowance is scrapped before then and you gain access to the fund with no tax charge.

    If the lifetime allowance still exists at this point, you can opt to pay a reduced rate of 25% on the excess. You can then leave the funds invested to continue to grow.

    Tax-Free Lump Sum

    Under pension freedoms in the UK, you are entitled to take 25% of your pension fund as tax-free cash when you retire. This is limited to 25% of the prevailing or protected lifetime allowance.

    Tax-free cash is still available using a QROPS at 25%, and at 30% in some jurisdictions. However, this is based on the full value of the fund, not limited by the prevailing lifetime allowance.

    For higher value pensions this can be advantageous, due to the increase in tax-free cash that would be available.

    Income from a QROPS

    As a UK resident, the income will be taxed in the same way as any other UK pension scheme. You still have the full use of your personal allowance, and basic and higher rates of tax remain the same.

    Should you live abroad, tax will be paid subject to the rules in the country of which you are tax resident.

    Inheritance tax & QROPS

    Under pension freedoms the rules are similar, however, somewhat more advantageous through a QROPS.

    If death should occur:

    Pre age 75 – Under UK rules the value of the pot can be paid out tax free to the beneficiaries. This is limited to the prevailing or protected lifetime allowance. Any excess will still be charged as lifetime allowance at either 25% or 55%, and paid by your estate.

    With a QROPS this is not the case. The full value of the fund can be paid tax free, and there is no lifetime allowance consideration.

    Post age 75 – Under UK law the pension fund is inheritance tax free. However, income tax is paid on any withdrawal from the pension.

    QROPS is very similar, with the beneficiaries paying income tax on any withdrawals. However, there may also be the option of some tax-free cash. The original value of the transfer to the QROPS, plus any tax-free cash and income taken are deducted from the gross value of the fund at the time death occurs. Any excess can be paid as tax-free cash to the beneficiaries.

    Can you use a QROPS if you are a UK resident?

    The common understanding is that UK residents cannot use the schemes. However, after recently conducting our own due diligence we concluded that there is nothing in the legislation that excludes UK residents from using one.

    This was recently confirmed by the independent government body, the Pensions Advisory Service who also confirmed that QROPS can be used by UK residents.

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