Tax Efficient Management of the Lifetime Allowance Charge

GUIDE 5 OF 6

In previous guides we have discussed the different ways to draw funds from pensions and how the LTA charge will vary depending on the chosen route. Below, we now explore how the LTA charge can be managed from a tax perspective, based on a clear understanding of an individual’s current situation and future plans.

Note, there may be situations where the options below do not apply, such as if tax free cash has already been drawn from other pensions or if there are Defined Benefit pensions that also need to be considered.

Drawing Tax Free Cash

A simple way to minimise the LTA charge is to draw the tax-free cash allowance as the pension is approaching or hits the LTA; you are able to draw 25% of the LTA tax-free. If the tax-free cash is not withdrawn and remains within the pension, any growth on the tax-free funds over and above the LTA limit will face additional tax charges.

Once withdrawn, the tax-free cash can be invested into tax efficient wrappers, such as ISAs and General Investment Accounts (GIAs). However, the withdrawal can increase the individual’s estate for IHT purposes.

Managing the LTA Excess Charge

In a previous guide, we stated that higher and additional rate taxpayers could pay funds into a pension, even if the pension value exceeds the LTA, and then potentially benefit from lower levels of taxation on withdrawal. We illustrate below how this might work in practice.

John is an employee of a tech company and earns £75,000 p.a. He is awarded a bonus of £25,000 and can choose to receive these funds either personally or paid directly into his pension by his employer. He is already over the LTA, has taken his full entitlement of tax-free cash and has no need for the funds in the short term.

  • If paid personally – John receives the funds after a 42% tax charge: 40% income tax and 2% National Insurance (increasing by 1.25% in the 2022/23 tax year). He receives £14,500 net.
  • If paid to his pension – John’s pension receives the contribution instead with no immediate tax liability. There is also no personal tax relief applied as the company made the contribution. He decides to wait until after he is retired to draw the funds.
  • Once retired, John chooses to draw the funds in a tax year when he has no other income. He elects to designate his funds to drawdown and pay an initial 25% charge of £6,250.
  • He then withdraws the residual £18,750. The first £12,570 is within his personal allowance (based on current allowances) and the £6,180 in excess of this is taxed at 20%, leaving a net payment of £17,514.
  • This is a net tax charge of 30% i.e. 12% lower than if he drew the funds personally.

Two caveats to this point. If John’s total earnings were between £100,000 and £125,140 in the tax year he received the bonus, he would have faced a 60% income tax charge; the personal allowance is reduced and then lost between these amounts. This may mean it makes even more sense to favour pension contributions. Moreover, if his taxable estate was over the available Nil Rate Bands, then IHT may be due at 40% of the excess.

Second LTA Test

As previously discussed, it is not only the uncrystallised funds in excess of the LTA that can be caught by the LTA charge. Previously crystallised funds can also fall foul of a second LTA test at age 75, if they have grown in the intervening period.

This charge can be reduced (or removed) by withdrawing the crystallised gains from the pension as the scheme beneficiary approaches 75 year of age. They key is to ensure that the value of the crystallised funds at age 75 is at or below their starting value. As we previously noted, this is a complex area that is heavily influenced by an individual’s circumstance; if this might prove relevant, we recommend speaking with a wealth manager.

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