Pensions

PENSION SAVERS WITH SUBSTANTIAL FUNDS SHOULD NOT SLEEPWALK TOWARDS AGE 75

Julie Sebastianelli looks at the lifetime allowance and why pension savers need to plan ahead to avoid sleepwalking into an unexpected tax liability. 

Julie Sebastianelli
Wealth Management Director
11 October 2021
3 minutes

Prior to the Budget of 2014, for individuals with significant pension savings in defined contribution schemes the conventional wisdom was to draw down on your pension fund, reducing it as much as possible to mitigate the taxation on funds remaining on death. The pension freedoms introduced in 2015 changed that through the introduction of more flexible pension payments and by widening the scope of beneficiaries to whom the passing of funds could be made free of inheritance tax (IHT) and, if under age 75, also income tax. 

At a stroke, for many it became more beneficial to draw down on personal investments including Individual Savings Accounts, thus reducing the value of the taxable estate (on death) and leaving pension capital untouched. Where income is required from a pension fund the flexibility offers plenty of scope for legitimate income tax planning. 

These are sound strategies with the expectation of a pension fund increasing in value over time. For those whose pension savings fall well below the lifetime allowance (LTA), this is unlikely to be an issue, but for some a nasty sting in the tail could be waiting. This is because an individual’s pension is not just tested against the LTA on the date benefits are drawn, they are also retested on movement between income drawdown and annuity (prior to age 75 and were bought from crystallised funds) or on reaching age 75 in drawdown (see below). 

These tests assess the value of an individual’s fund at the appointed date, less the value of the fund that was placed into drawdown (after taking the tax-free lump sum). Any increase in value is tested against the individual’s remaining LTA. If there is insufficient available LTA, part of that increase will be taxable as an LTA tax charge.  

Example – Alison (age 65) 

Alison has previously applied for and been granted Fixed Protection 2016. Subject to her not making any further contributions or accruing benefits since 6 April 2016, she has a fixed LTA of £1.25 million. She has a pension fund valued at £1.125 million at age 65 and she crystallises her entire fund, using 90% of her available LTA, receiving a tax-free cash sum of £281,250 and the balance of £843,750 is designated to her flexi-access drawdown fund. 

Alison does not need an income from her pension as immediate income needs are met from personal investments; she wants to leave an IHT-free legacy to her children and grandchildren. Her income drawdown fund remains invested. At age 75, and assuming a compound return of just 3% per annum for 10 years, the fund value would have risen to £1,138,517, an increase of £294,767. 

Her 75th birthday will trigger a second LTA test, this time only on any increase in the originally crystallised amount designated. Remember that Alison will have only 10% of her LTA remaining (£125,000). Therefore, the excess of £169,767 will be subject to a lifetime allowance tax charge. There are normally no further LTA tests post age 75. 

When does this liability have to be paid? If she has left the fund untouched, there is a tax charge of 25% of the excess, or £42,441.75. The tax due would become immediately payable by the pension fund. Income tax may also be payable on any subsequent withdrawals from the remaining fund, either by Alison or her beneficiaries after her death, depending on their tax position. 

With this knowledge, Alison can consider a number of options depending on her own tax position and objectives. These might include retaining assets in the estate to pass on in the knowledge of the LTA charge and a possible IHT charge, a combination of personal investment income and pension income drawdown, as part of a coordinated strategy of gifting away to her heirs, or greater pension income withdrawals to reduce any excess, bearing in mind these will be liable to income tax and possibly IHT, unless spent on intangible items such as holidays etc.  

This example highlights how important it is for clients to have a close relationship with their adviser, and for advisers to proactively identify future issues even though they may (as is the case here) be ten years’ away. 

To find out more on this subject visit www.mattioliwoods.com

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