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Consequences of breaching the LTA

1 January 2018

With an increasing number of people likely to exceed the Lifetime Allowance, what are the consequences when they do? A case study from Martin Tilley, director of Technical Services, Dentons Pension Management

We are often told stories by our adviser network of their clients stopping contributions, or more often, revising their investment strategy so that they will not exceed the lifetime allowance (LTA). From our own experience, there is often a misunderstanding by clients as to when a fund is tested against the LTA and what the tax implications will be.

Granted while this is a problem, sometimes it can be a nice one to have.

The LTA has mirrored Isaac Newton’s well-known quote by going up since its introduction in 2006 to its peak of £1.8m in 2012 before coming down again to its current low of £1m. Having escaped any further amendments in the 2017 Autumn Budget, it will increase in line with CPI from 6 April 2018 to £1.03m.

With positive returns for most markets in recent years, it is likely that more people will potentially reach or breach the LTA. However, what is the downside and if planned for, is this so bad?

Case study

Let us take a hypothetical pension fund member who is 60 years old and has managed to achieve a fund value of £1.4m but who, through lack of appropriate planning, is subject to an LTA of £1m.

They are intending to drawdown fully on their pension fund in January 2018 and are not willing to wait until 6 April 2018 when they could enjoy an additional tax-free lump sum amount of £7,500. Assuming they have not used up any LTA in any other pension schemes and do not wish to buy an annuity, their main options would be:

1. Put the entire £1.4m into payment and take the maximum tax-free lump sum of £250,000 (i.e. 25% of £1m), with £750,000 remaining in the pension fund for drawdown. Take the £400,000 excess above the LTA as a lump sum, which would be subject to an LTA tax charge of £220,000 (55% of £400,000). The remaining £180,000 (45% of £400,000) and the tax-free lump sum are then in the hands of the client and subject to their personal income and inheritance tax regime.

2. As in option 1, but designate the £400,000 excess for drawdown rather than take it as a lump sum, in which case the LTA tax charge would be £100,000 (25% of £400,000). The remaining £300,000 is then available, along with the £750,000, for taxable drawdown payments from the pension fund. Provided the client’s total income, including drawdown payments, remains below the higher rate threshold of £45,000 for 2017/18, drawdown payments should only be subject to income tax at a maximum rate of 20% (whilst current rates prevail).

The combined rate is therefore effectively 40% (25% of £400,000 and then 20% of £300,000) as opposed to the upfront 55% tax charge if the client took the excess as a lump sum. They could also draw funds into their personal tax regime as and when required while the remaining pension funds continue to grow in a tax-favoured environment.

3. Put only £1m into payment and take the maximum tax-free lump sum of £250,000, with the remaining £750,000 available for drawdown. The £400,000 excess above the LTA remains in the pension fund as unvested funds and will not trigger an LTA tax charge until the client vests them or, if earlier, the client’s 75th birthday or death.

Death before age 75

What is the treatment of these funds in the event of the member’s subsequent death before their 75th birthday?

In the case of options 1 and 2, the pension fund trustees can distribute the pension funds to the deceased member’s beneficiaries at their discretion in the form of lump sums and/or drawdown pensions to dependants and/or nominees. Lump sums paid and/or drawdown pensions designated within two years of the date the scheme administrator first knew of the member’s death, or, if earlier, the date on which they could first reasonably have been expected to know, will be tax-free.

In the case of option 3, the situation will be as above except the unvested funds will be subject to the LTA test and a LTA charge of 25% due. However, if instead they remained unvested beyond the two-year period, the LTA test would not apply but lump sum payments and/or drawdown payments from those funds would be subject to tax. Lump sums and/or drawdown pensions to individuals would be taxed at the individual’s marginal rate of income tax and lump sums to entities at the special tax rate of 45%.

Clients should ensure that their nomination form, setting out their intended beneficiaries, is with the scheme administrator and a new form provided when any changes are required.