The financial planning journal

How to manage the Lifetime Allowance to make your retirement savings work harder…

21 January 2021

Did you know that the Lifetime Allowance (LTA) tax charge on your pension could be costing you more than 55% of your hard-earned retirement savings?

The 55% tax charge for exceeding the LTA sounds intimidating enough, however, many people end up with an effective tax charge of more than this. Ironically, this is often the result of trying to beat the system.

What is the Lifetime Allowance?

The Lifetime Allowance (LTA) is the limit of the funds an individual can build within their combined pensions during their lifetime before incurring an LTA tax charge. Now, there are two important words used within that explanation that can easily get overlooked:

“Build”
“Combined”

Build – This is important to note as any growth that is made on top of your pension contributions is also included when assessing the LTA, along with any basic rate tax relief that is claimed at source for personal contributions.

Combined – All of your pension pots count towards the LTA. This means that if you are lucky enough to have an old Defined Benefit pension that you will need to factor this into any calculations also. This is typically based on 20x your annual pension at retirement plus any tax-free cash however there are many more complexities with pensions in payment pre/post 2006 and therefore it is important that you seek advice if you are affected by this.

The trap

If you are fortunate enough to have pension assets that are in excess of the LTA, you have two options when it comes to paying the charge:
• Take benefits in excess of your LTA as a lump sum and suffer a 55% tax charge.
• Take benefits in excess of your LTA as a regular income and suffer a 25% tax charge.

At face value, it’s a no brainer to take the second option and pay the reduced charge, even if it means waiting that little bit longer to buy your new toys. However, it’s at this point that you could fall into the trap – let’s take a look:

Case study

Current LTA: £1,073,100
Current Fund Value: £1,173,100

Assuming that all three clients below are crystallised up to the standard LTA and have no form of protection, you can see the difference in the effective tax charge for taking their benefits in excess of the LTA as regular income:

Basic rate taxpayer Higher rate taxpayer Additional rate taxpayer
Excess benefit £100,000 £100,000 £100,000
LTA charge (25%) £25,000 £25,000 £25,000
Net Sum £75,000 £75,000 £75,000
Income tax due on remainder £15,000 £30,000 £33,750
Net income £60,000 £45,000 £41,250
Excess benefit 40% 55% 58.75%

 

As you can see, the only real winner in this scenario is the basic rate taxpayer. Government figures identify an 8.8% increase in pensioners who were additional rate taxpayers in 2019/20 compared to 2018/19. Whilst all of their income may not be generated from pension wrappers, the unfortunate truth is that they will still be eligible to be snared by the LTA.

Awareness

The real way to manage (manage as opposed to avoid) the LTA tax charge is to ensure that you are aware of it. You can’t expect to improve your financial wellbeing and comfort if you aren’t mindful of the obstacles that may be in your path.

In doing so, you are taking the first steps to becoming more agile in retirement. Once you have identified an issue, the next logical step is to find a solution and, in this case, changing your mindset to ensure that you do not class your “retirement” as just your “pension” can be the answer.

A simple set of standard assumptions can help you predict whether you are likely to breach the LTA in the future. However, what you choose to do next is what will save you that hefty 58.75% effective tax charge. You need to ensure that you utilise allowances within other tax wrappers as opposed to just your pension. This allows you to draw from multiple income streams and turn them on and off at your behest to control your tax liability. Consider them your very own tax taps.

The “taps”

• Individual Savings Account (ISA)
• General Investment Account (GIA)
• Investment Bonds
• Alternative Investment Market (AIM)

Now, not everyone will be in the position to fund multiple wrappers, so the key takeaway is the importance of the balancing act. This is just as vital in the accumulation phase as it is in retirement: you’re less likely to get that nasty LTA tax charge surprise if you have been actively balancing your “taps” from an earlier age.

In practice, you can draw tax free income from your ISA; utilise your capital gains allowance within your GIA; benefit from tax deferred withdrawals from an investment bond; reduce your inheritance tax liability with AIM shares in place of pension funding; all whilst maximising the tax allowances afforded to you on an annual basis. A blend of these tactics, plus many more, allows you flexibility to control your tax position in retirement and turn on/off any taps as and when you need to.

Use these tactics effectively and you can easily draw well in excess of £125,000 per annum whilst remaining a basic rate taxpayer. Indeed, the additional rate taxpayer in the aforementioned case study could have saved £18,750 by using the above blend.

New car…or £18,750 tax bill?
Help the kids on the property ladder…or £18,750 tax bill?
Around the world cruise…or £18,750 tax bill?

It’s never too early to start planning this process and it will, of course, be different for everyone. People have their own goals and ambitions and often more than one, so why only have one retirement pot? Avoid the 58.75% and take that world cruise…

Saltus Financial Planning Ltd is authorised and regulated by the financial conduct authority. Information is correct to the best of our understanding as at the date of publication. Nothing within this content is intended as, or can be relied upon, as financial advice. Capital is at risk. You may get back less than you invested.

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