Lifetime Allowance Charge – are there strategies for mitigation?

  • Author : Novia Financial
  • Date : 23 Feb 2021

Since the pension ‘simplification’ in 2006, the tax benefits of all types of pension scheme have been limited by the same two allowances: the Annual Allowance (the belt) and the Lifetime Allowance (the braces). The first affects the amount that goes into a pension, the second affects the amount that eventually comes out.

Many have asked, do we really need both allowances? If you limit what goes in, then surely what comes out would be naturally limited? If you limit what comes out, then the inputs would be restricted by necessary and effective planning. By operating two entirely separate yet equally complex allowances, an opportunity for true simplification has perhaps been missed.

The Lifetime Allowance promises future tax revenues to the government in situations where high earners are not in full control of their pension inputs (for example in final salary schemes) or where stock markets present wealthy individuals with higher than anticipated growth over the long term.

The allowance was set at £1.5 million – it rose, it fell, and it rested at one million. It’s now on a shallow ramp to keep up with inflation.

Nobody wants to pay a Lifetime Allowance charge, but those whose wealth is in the bracket where this is a possibility are at least likely to have the luxury of paying someone else to do the worrying for them. If they already have a large amount in their pension pot – a million, say – and they’re too young to crystallise any benefits,  there’s not much they can do about the Lifetime Allowance but watch the race play out between their investments and inflation. Now, you’d expect the investments to win this hands down, but they might not necessarily be cheering them on – at least, not yet. If the growth remains modest until they reach 55 then they have the option of crystallising their whole pension, triggering the test against the Lifetime Allowance and merrily halting their progress into the red. But when they wake up on their 55th birthday, after the champagne and smoked salmon breakfast in bed is out of the way, is that really going to be their next move?

Their 55-year-old self might be tempted to leave that pension pot uncrystallised, especially if they’re still earning and don’t need to access the savings. Sure, in 20 years’ time there will be a compulsory bean count at age 75 to sweep up any untested benefits… but perhaps they’re less concerned about tomorrow’s problems. Maybe they think that, by the time they’re 75, Lifetime Allowance and all its complexity might be a thing of the past. When it comes to pensions legislation, a lot can happen in twenty years.

Based on the rules we have now though, the Lifetime Allowance train has no toilet cubicle to hide in. If the fund is left growing in accrual until the age of 75, it’ll be tested (see blue section below). If death comes before age 75, it’ll be tested upon this untimely demise. If one crystallises it all now and stashes it in a drawdown, even the growth on that drawdown will be tested (see red section below) upon reaching that golden age.

So what can be done?

Some would say the optimum time to start taking benefits is at the last possible moment before the pension’s value overtakes the Lifetime Allowance. One could crystallise the lot and stash it in a drawdown, where the growth can be managed via regular income withdrawals. Or it could be left in the accrual pot and regular Uncrystallised Funds Pension Lump Sums (UFPLS) could be taken to offset some of the growth of the fund. Either way, the options improve once you get to pensionable age.

There are options too for mitigating Lifetime Allowance charges if and when someone crystallises beyond the threshold. When crystallising to drawdown, the ‘excess’ can be taken one of two ways: as a Lifetime Allowance Excess lump sum, charged at 55% and paid to the client’s bank account, or as a ‘retained amount’ charged at 25% and moved into the drawdown pot. The lower tax charge for the latter option takes into account the fact that PAYE will operate when that money is eventually withdrawn.

If the pension is the primary source of income and HMRC points the individual’s tax bands at their pension scheme, then the PAYE system can potentially be utilised to pay less tax overall. If they have the patience to withdraw their excess over time, they may find that more of it ends up in their pocket.

For example, imagine a £400,000 excess being handled as a retained amount. HMRC will take £100,000 (25%) as a Lifetime Allowance charge. The remaining £300,000 would be designated to drawdown. If that were withdrawn gradually as income (£50,000 per year), then after six years of withdrawals they’d have taken out the entire excess and it could have cost them £145,000 (100k Lifetime Allowance charge and 45k PAYE). This is very different to the £220,000 of Lifetime Allowance charge they’d have stumped up if they’d pulled their excess out as a lump sum at the point of crystallisation.

The illustration below is for a Lifetime Allowance excess of £400,000. It assumes a personal allowance of £12,500 and a basic rate band of £37,500 and that these allowances are accessible via the pension scheme.

So, Lifetime Allowance can be a complicating factor for wealthy individuals. It’s fair to say that pensions aren’t the only source of income, and tax isn’t the only relevant factor when coming up with a pension withdrawal strategy – so Lifetime Allowance mitigation might not be on the first page of the list of considerations. Nevertheless, it’s worth keeping an eye on.

Please note: since publication of the above article, the government has announced that legislation will be introduced in the Finance Bill 2021 to remove uprating in line with the consumer price index for tax years 2021 to 2022 up to and including 2025 to 2026. The amount of the pension lifetime allowance for tax years 2021 to 2022 up to and including 2025 to 2026 will remain at £1,073,100



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