The Lifetime Allowance – Tax, Tests and Protection

Today’s post is about the lifetime allowance on pension benefits. The LTA caps the amount you can take from your pension without paying more tax.

What is the lifetime allowance?

The Lifetime Allowance (LTA) is a limit on the amount of money that can be taken from your private pension schemes – as either lump sums or retirement income – before an extra tax charge is due.

• Normally, the first 25% of your pension is tax-free, and the rest is assessed as income for that tax year.

The Lifetime Allowance was introduced in 2006 – as part of the “A-Day” changes – at £1.5M.

• It then increased each year to 2010, when it reached £1.8M.

Since 2013 it has been gradually reduced, and hit £1M (from £1.25M) in April 2016.

• The LTA will be indexed to inflation (CPI) from 6th April 2018.

What’s wrong with a lifetime allowance?

There’s nothing wrong with a lifetime allowance in principle, but there are two things wrong with the current LTA in practice.

First, it’s assessed on withdrawals rather than contributions.

• This means that successful investment practice can be penalised, since a good rate of growth will push you over the limit.
• It also makes it very difficult to work out when to stop paying into a pension, since you have to make some assumptions about future growth rates and withdrawal patterns.

An LTA based on contributions would be more sensible and would simplify the calculations.

• With an annual limit of £40K, a £1M LTA on contributions would still allow for 25 years of paying in.

Second, at £1M the LTA is probably now too low.

• A pension pot of £1M would currently buy a 55-year-old man an annuity of £18.1K pa¹

The government has no need to subsidise (through tax breaks on contributions) a generous retirement for all, but with interest rates as low as they are, the LTA should be around £1.5M.

• That would support an annuity of £25K pa, which should be enough for most people.

It’s possible that the government’s logic is that the state pension will top up your annuity by another £8K, taking your total income to £26K (of which £2.9K would be taken in tax).

• But most people won’t get the state pension until at least age 66 or 67.
• So there is an 11- or 12- year gap between accessing a private pension at 55 and getting your top-up from the state.

Extra tax

Once you have used up your LTA, any further cash taken as income (from an annuity or drawdown scheme) will have 25% extra tax deducted.

• Any further cash taken as a lump sum – which must be done before age 75 – attracts a whopping 55% extra tax charge.

This extra tax – known as the Lifetime Allowance Charge (LTA charge or LAC) is intended to recover the tax that was not collected when the “extra” contributions were paid into the pension.

Generally speaking, for a higher rate taxpayer, the income option will incur the same total tax as the lump sum.

• For an additional rate taxpayer the income option will be worse.

For a basic rate taxpayer the income option is better, and should mean a maximum tax rate of 45%.

• In practice this could work out as around 36% (see below).

An example

In tax year 2017/18, if you withdrew £60K (via UFPLS), then:

• the first 25% is tax-free (unless you previously withdrew 25% as a tax-free lump sum), leaving £45K that will be treated as income
• the first £11.5K of this will be set against your annual tax-free personal allowance
• the remaining £33.5K will be taxed at 20%

So on a £60K withdrawal you will pay £6,700 in tax, leaving you with £43,300 to spend (or invest).

• That’s an effective tax rate of 11.2%.

That £60K withdrawal represents 6% of your lifetime allowance, and your pension provider will write to you to say that you have used up that much.²

• Withdrawing more than £60K in a single tax year would not be tax efficient, unless it included the 25% tax-free lump sum.

Protection

Each time the LTA is reduced, the government offers “protection” options that allow you to keep the earlier, higher limit.

• So when the LTA was reduced to £1M last year, I took out protection to keep the £1.25M limit.
• The cost of this is that I can’t make any further contributions to my pension.

There have been four types of protection:

1. primary
2. enhanced
3. fixed
4. individual

Some of these are only available to those with benefits that already exceeded the previous higher limit, while others are available to all.

For the 2016 change to the LTA, only fixed and individual protections were available:

1. fixed protection was for those with less than £1.25M in their pension
   • to qualify, no benefits can have been accrued to your pension since 5th April 2016
   •  you need to watch out particularly for employer contributions, for example from a new auto-enrolment scheme
2. individual protection was available to those with more than £1.25M in their pension at 5th April 2016

Crystallisation events

Each time you access a pension, there is a “benefit crystallisation event” (BCE).

• This means that the benefits you receive are assessed against the LTA to see if any extra tax is due.

So this applies to:

1. starting to receive income from a (workplace) DB pension
2. starting to receive income from a DC pension
3. converting some of your pension into an annuity
4. taking your tax-free 25% lump sum (either style of pension)
5. taking a one-off lump sum (known as UFPLS) from a DC pension

There’s also another test at age 75, on your remaining pension assets (a “haircut”).

• And your death can also trigger a BCE.

There were originally nine types of BCE, but now there are 13.

• We’ve only covered seven of them so far.

The others include:

• increase of a scheme pension already in payment to a member beyond a permitted margin
• three extra flavours of the test at 75, depending on what you have done up to then

The full list can be found here.

There are:

• 4 for accessing income
• 5 for treatment at age 75 (including two for death)
• 1 for lump sums
• another one for death
• transfer to QROPS (an overseas pension scheme)
• one for assessing things that aren’t supposed to happen (“arrears”, excessive lump sums etc.)

Calculating the percentage used up

In most cases, the cash amount is converted to a percentage of the prevailing LTA (normally the current LTA, but a higher one if you have taken out protection), and this percentage is added to the amount you have used up.

When you move your pension into drawdown, or spend some of it on an annuity, it’s the total amount used in the transaction that is used, not the annual income.

• So if you took £250K as a lump sum and moved £750K into drawdown, you would have used up 100% of the current LTA.

DB pension conversion rates

In the case of income from a DB pension, the number used in the calculation is 20 times the annual income from the pension.

• This conversion factor used to be 25 times, but was cut way back in 2006.
• A conversion factor of 25 is still used for old pensions (those that began to pay out before “A-day” – 6th April 2006).

This conversion factor of 20 is a great arrangement for those with a DB pension.

• It means that a DB pension of £50K pa won’t lead to an LTA charge.
• Whereas a DC pot of £1M can only produce an annual income of £18K.

As we saw earlier, annuity rates are currently 1.81%.

• This implies a fair conversion factor of 55 times ( 1 / 0.0181).
• You might be aware that many pension schemes are currently offering conversion rates of more than 40 to induce DB pensioners to transfer to DC schemes.

Even using a typical pension safe withdrawal rate (SWR) of 3.2% would imply a conversion rate of 31 times.

The “second test” at 75

Drawdown pots are assessed again at age 75.

• The number used this time is the value of the pot minus the original number that was allocated to drawdown.

Let’s say you had an £800K pot at retirement.

• You put £600K into drawdown and take £200K as cash.
• This uses up 80% of the LTA, leaving 20% still to use.

Ten years later, if you take no income from the drawdown pot, the fund might be around £850K.

• The LTA should have been indexed up to £1.28M by then.

So the calculation is:

• 850 – 600 = 250 of growth
• 250 / 1,280 = 19.5% of LTA used

So no extra tax would be due, because in this case the growth rate of the pot is not much more than inflation (3.6% vs 2.5%).

If your pot is growing at a rate significantly higher than inflation, it would be better to draw income from the pot so that you don’t breach the LTA.

• Of course if this requires you to draw a lot of income (more than the basic rate limit), you will pay an additional 20% in income tax on the extra.
• Which could cancel out the benefit of avoiding the LAC.

Those wanting to use the pension to pass money to their heirs might prefer to take the LTA charge rather than draw money out of their pension.

Conclusions

The LTA is a particular consideration for younger investors, who have to try to forecast the impact of many future years of contributions and (hopefully) growth.

For those close to retirement age, it is easier to predict whether you will breach the LTA.

• If you will, then take your 25% tax-free lump sum and convert the rest of your fund into drawdown.
• If you already have, take out protection.

Once in drawdown, keep an eye on the growth of your fund and be sure to draw enough income that you keep the size in the pot below a level that would use up your remaining LTA.

• That’s because when you hit 75, your drawdown pot will be assessed for a second time.

Until next time.

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1. Index-linked – a flat annuity of £39.2K is also available [↩]
2. Technically, the percentages are not used in testing whether the LTA has been breached – the previous withdrawal is revalued at the current LTA value – but the two methods produce very similar results [↩]