Pension Tax and the Lifetime Allowance

GUIDE 2 OF 6

Before we look specifically at funds in excess of the LTA, we should briefly outline the tax treatment of a pension fund. Please note, this focuses on Defined Contribution (DC) pensions; the tax treatment of Defined Benefit (DB) pensions is different and we encourage you to speak to a wealth manager, scheme administrator or Trustee if you have a DB scheme.

For Defined Contribution pensions:

  • Before any funds have been drawn from the pension, the total value of that pension will be known as being ‘uncrystallised’.
  • From the age of 55, Individuals are usually able to take 25% of their pension fund tax-free, up to the LTA (currently this equates to £268,275).
  • Having taken the tax-free allowance, the remaining 75% of funds within the LTA are known as ‘crystallised’ and are usually placed in ‘drawdown’. Further withdrawals are taxable at the recipient’s marginal rate of income tax and may involve LTA charges.
  • Any funds within a pension will likely fall outside of an individual’s estate for Inheritance Tax (IHT) purposes.

None of the events noted above will trigger a charge on the funds in excess of the LTA. This will occur when:

  • The pension holder reaches age 75.
  • The pension holder dies before age 75.
  • Funds in excess of the LTA are withdrawn, before the pension holder reaches age 75.

For the first two events, a 25% tax charge will automatically be levied on the LTA excess.

However, for the third event there are two ways in which an individual can choose to be charged: by taking the funds as a lump sum or designating them for drawdown. See below for further detail. 

Lump sum Charge

For funds that are in excess of the LTA, if these are drawn as a lump sum, or a series of lump sums, before the age of 75, they will be taxed at a one off rate of 55%. Once this charge has been taken, the remaining 45% will be paid to the member’s bank account and nothing further is payable.

See the chart to the right for an example of how this would work in practise for David, if he took his excess funds as a lump sum.

Drawdown DESIGNATION Charge

In this scenario, any funds in excess of the LTA will potentially face two tax charges. Initially, an individual designates the excess funds for drawdown, making them subject to a 25% tax charge; this is paid out of the pension funds. This effectively crystallises the funds, but they remain in the pension wrapper. Should the individual wish to withdraw them, they would then be subject to the individual’s marginal rate of income tax.

See the chart to the left for an example of how it would this would work in practise for David, this time if he elected to draw the funds via drawdown designation. 

Second Test at 75

We note that there may be an additional LTA excess charge on the crystallised funds at age 75. The precise charges will reflect an individual’s circumstance and should be discussed with a wealth manager or pension tax specialist.

If you would like to discuss ways in which you can manage your LTA charge, please contact a wealth manager.

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