Financial planning

Sleepwalking to age 75

When you have spent a lifetime dreaming of enjoying your retirement, safe in the knowledge you have enough put aside in your pension, the last thing you want is to be hit with an unexpected tax charge as you turn age 75. Never rest on your laurels; changes happen and sleepwalking through them might cost you dear.

10 November 2022

In 2015, new pension ‘freedom rules’ provided greater flexibility in terms of payment and accessibility. At the same time, there was a widening of the scope of beneficiaries to whom the passing of undrawn funds could be made free of inheritance tax (IHT).

The favourable IHT position pensions enjoy has seen an increase in clients using their personal wealth to fund their lifestyle, with a view that this would help reduce their taxable estate on death. In this scenario, clients prefer to view their pension pots as ‘next generation’ monies.

However, you need to be mindful you are not caught by a lifetime allowance (LTA) tax charge. The LTA is the total amount you can build up in all your pension savings without incurring a tax charge. Any excess could be taxed at 25% and potentially up to 55%. The standard allowance for the current tax year (and until April 2026) is £1,073,100. 

You will not use any of your LTA until you start taking benefits from your pension arrangements. When this happens, it is known as a benefit crystallisation event (BCE) and at each event your pension is tested against the LTA to see whether an LTA tax charge is due.

At age 75, everyone’s pension is tested against their LTA. This is the case for all schemes, whether they have been crystallised or not, and can create a nasty surprise for some. There are other BCEs to consider but these are beyond the scope of this article.
 
It is possible to maintain the LTA at a higher level through one of the protections that have been available. This is an essential planning tool for individuals who have, or may have, pension savings in excess of the LTA. There are two LTA protections currently still available: fixed protection 2016 (FP16) and individual protection 2016 (IP16). Each type protects the LTA at or up to £1.25 million but with different considerations and conditions. This is where expert advice can be most valuable.

Protecting the LTA does not mean you can avoid the LTA charge, as any BCE at a time when the fund is over the appropriate LTA limit will trigger a tax charge. The example below illustrates this important point.

The case of Mr Affleck

On 5 April 2016, Mr Affleck’s pension is valued at £1.2 million and he is aged 68 and 11 months. He applies for IP16 to protect the pension benefits he has accumulated. Individual protection protects the LTA at the lower of £1.25 million or the value of the pension on 5 April 2016. In this case, Mr Affleck has protection at £1.2 million gaining protection on £200,000 as the Government reduced the LTA to £1 million on 6 April 2016, later increasing it by RPI annually until it was frozen in 2021 at £1,073,100.

In May 2020, Mr Affleck chooses to access his tax-free cash; however, due mainly to the volatile investment markets at the time of the pandemic, his pension has fallen in value to £1.1 million. Accessing his pension triggers an LTA test against the £1.2 million. This uses up 91.66% of his allowance. Any further growth and/or contributions (which Mr Affleck can still make with IP16 as opposed to FP16, where further contributions are not allowed) that cause the fund to exceed the remaining 8.34% at the next crystallisation event will then be subject to the LTA tax charge.

By May 2022, Mr Affleck has made a pension contribution of £40,000 in each of the last two tax years and has also seen some investment growth of £5,000 on this. 

Mr Affleck is 75 in May 2022, which means his pension will be tested against the LTA for the last time.

Firstly, the uncrystallised benefits are tested against the remaining allowance. Mr Affleck has £100,080 of unused LTA (8.34% of £1.2 million) and as £85,000 is within this amount, there would be no LTA tax charge. However, 7.08% of the LTA would be used up, leaving just 1.26%.

The £825,000 he had left in his pension has now grown to £912,000. The increase of £87,000 less his remaining LTA of £15,120 leaves an excess of £71,880. This excess will now attract an immediate 25% tax charge of £17,970. The liability becomes immediately payable by the pension fund.

This is not the end, as if Mr Affleck draws some of these excess funds from his pension in the future, he will be subject to income tax at his marginal rate – even though he will have already been charged 25%. The same applies after his death when his beneficiaries draw from their inherited ‘designated fund’.

The above example shows how important advice is, as pensions now have greater flexibility and with that comes greater choices for individuals. It is not a straightforward decision to leave the pension untouched in the knowledge that an LTA charge may be lurking. At Mattioli Woods, we can help you with your retirement plans. We stay close to our clients and help them proactively identify future issues, even though (as illustrated with Mr Affleck) they may be some years away. 
 

This article was written by Megan Leach, Trainee Consultant. 

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