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In the words of Bananarama ‘It ain’t what you do (it’s the way that you do it)’

27 November 2017

As a result of gradual reductions to the standard Lifetime Allowance (LTA) over the last few years, more and more clients are now subject to a LTA excess. Where a client’s benefits exceed their LTA there is no way to avoid the excess tax charge. However, where they have a mixture of defined benefit and money purchase arrangements, the order that they take benefits in can affect what they actually receive. Sam Niblo, Technical Specialist at Prudential takes us through some examples.

Let’s consider Robert, who has previously taken benefits from one of his defined benefits (DB) schemes and used up 48.24% of his LTA. He then applied for Individual Protection 2014 and has a protected LTA of £1,398,995. He also has the following benefits which he has not yet taken:

 Scheme Type Current Value Full Pension Max PCLS Reduced Pension DB Scheme 1 N/A £19,844 £62,615 £14,626.08 DB Scheme 2 N/A £7,215.00 £31,255 £5,131.33 DB Scheme 3 N/A £3,514.50 N/A N/A MP scheme £495,984 N/A N/A N/A

Scenario 1 Full Pension Commencement Lump Sum (PCLS) with Defined Benefit first

If Robert takes benefits from all his defined benefit schemes before his money purchase arrangement, and assuming he takes the maximum PCLS and reduced pension option where available, this would give the following:

DB scheme 1

LTA used = 20 x £14,626.08 + £62,615 = £355,136.60/£1,398,995 = 25.38%

DB scheme 2

LTA used = 20 x £5,131.33 + £31,255 = £133,881.60/£1,398,995 = 9.56%

DB scheme 3

LTA used = 20 x £3,514.50 = £70,290/£1,398,995 = 5.02%

Total LTA used = 88.20% (which includes the 48.24% used previously)

Money Purchase (MP) scheme

Robert wants to fully crystallise his fund of £495,984 to provide the maximum amount of PCLS and designate the remaining fund to drawdown. However, as he only has 11.8% of £1,398,995 = £165,081.41 of his LTA remaining, he can only take a PCLS of 25% of £165,081.41 = £41,270.35 and designate £123,811.06 to drawdown.

His remaining fund of £330,902.59 is a LTA excess, which he could take as a lump sum after 55% tax or designate it to drawdown after 25% tax. Any drawdown income taken will then be taxed at his marginal rate.

If he chose to take a lump sum the scheme administrator would deduct the 55% tax charge of £181,996.42 and pay this to HMRC and Robert would receive the residual payment of £148,906.17.

If he chose the drawdown option the scheme administrator would deduct the 25% tax charge of £82,725.65 before designating the residual fund of £248,176.94 to drawdown.

Scenario 2 Full PCLS with Money Purchase first

If Robert takes the benefits from his money purchase arrangement first, and again assuming he takes the maximum PCLS and reduced pension option where available, this would give the following:

MP scheme

LTA used = £495,984/£1,398,995 = 35.45% (this would give a PCLS of £123,996 with a residual drawdown fund of £371,988)

DB scheme 2

LTA used = 20 x £5,131.33 + £31,255 = £133,881.60/£1,398,995 = 9.56%

Total LTA used = 93.25%

DB scheme 1

LTA used = 20 x £14,626.08 + £62,615 = £355,136.60/£1,398,995 = 25.38%, however Robert only has 6.75% of £1,398,995 = £94,432.16 of his LTA remaining.

How a LTA excess is dealt with in a DB scheme is not quite as straightforward as in a money purchase arrangement and will depend on the scheme rules, the options available, the commutation factor they would use, etc. Below is just one example to illustrate how this could be dealt with:

A pension of £3,889.13 and PCLS of £16,649.56 will use up Robert’s remaining LTA.

The other £260,704.44 is a LTA excess and if we assume the full amount is taken as a lump sum, the scheme administrator would deduct a 55% tax charge of £143,387.44 and Robert would receive £117,317.

Alternatively, if the full LTA excess was taken as a scheme pension the scheme administrator would deduct a 25% tax charge of £65,176.11 and reduce Robert’s pension accordingly, by applying the scheme’s commutation factor of 12:1, giving a residual pension of £7,603.88 (i.e. £260,704.44/20 = £13,035.22 – [£65,176.11/12]).

DB scheme 3

LTA used = 20 x £3,514.50 = £70,290 and this entire amount is a LTA excess, and if we again assume this is taken as a lump sum, the scheme administrator would pay the tax charge of £38,659.50 and Robert would receive £31,630.50.

If the excess was taken as a scheme pension, the scheme administrator would pay the tax charge of £17,572.50 and, assuming this scheme has a commutation factor of 15:1, this would give a residual pension of £2,343.00 (i.e. £3,514.50 – [£17,572.50/15]).