How To Minimise Limetime Allowance Taxes

I have seen a resigned acceptance to the Lifetime Allowance charge and a rush to pay it as soon as possible in an attempt to minimise the overall tax. This makes sense on the surface, however it demonstrates a lack of understanding about how the tax works and ways in which, for most, it can be manipulated.

I have reported a few times that the pension Lifetime Allowance has been frozen until April 2026. This is a tax that was brought in with the Pensions Freedom legislation in 2006, however a number of protections meant most of those affected by the early limits were able to protect their pension funds in full.

Additionally, the Lifetime Allowance was originally set at £1.5m in 2006, rising to £1.8m in 2011 before tumbling to £1.5m, £1.25m and £1m in 2012, 2014 and 2016 respectively.

This combination of falling limits and lack of awareness of the available protections has resulted in the Government being willing recipients of bumper annual windfalls that show no sign of slowing.

From HMRC’s website “In 2019 to 2020, 8,510 Lifetime Allowance (LTA) charges* were reported by schemes through Accounting for Tax (AFT) returns. The total value of LTA charges* reported by schemes in 2019 to 2020 was £342 million. This is a 21% increase from £283 million in 2018 to 2019.”

* HMRC refer to it as the Lifetime Allowance charge, presumably to soften the blow. I will refer to it going forward for what it is, the Lifetime Allowance tax. I’ll also start abbreviating to LTA.

With the freezing of the LTA these figures are only going to get much higher in future years and with the Covid debt pile growing, there is zero chance of any shift in Government policy towards easing this stealth tax on what much of the population perceive to be a tax on the wealthy.

That, however, was what Inheritance Tax was once considered to be, before rising house prices brought middle England well within its clutches. I fully expect the pension LTA to be perceived in the same way in the future, by which time for many, it will be too late.

Before we cover the planning ideas, lets recall what the LTA is and what the taxes are.

This is aimed to be more of a Bluffers Guide than a Technical Manual. The LTA and in particular the calculation of the amount used up can be complicated. If you are uncertain, please seek advice.

What is the Lifetime Allowance?

The Lifetime Allowance (LTA) is the overall limit of tax privileged pension funds a member can accrue during their lifetime before a Lifetime Allowance tax applies. The standard Lifetime Allowance is currently £1,073,100 (2022-2023).

When a member takes certain benefits, and at some other times (such as attaining the age of 75 or on death before 75) the amount of LTA they have used is tested.

When the members' benefits, along with any other benefits they have taken, are over the LTA, a tax is applied to the value in excess of the LTA.

There are a number of different LTA protections available however I will not cover these here. You should know if you are protected and to what extent. If you have been paying into pensions recently, then chances are you won’t be one and are probably ineligible to apply now anyway.

Benefit Crystallisation Events (BCEs)

These are the points at which the LTA is measured. The overall value of your pensions, even if they are above the LTA, are not taxed until a BCE occurs.

There were originally 9 BCEs and now there are 13. These include:

• purchasing an annuity with your pension fund

• taking tax free cash

• moving into income drawdown

• dying

• your 75th birthday

• transferring to an overseas pension

Your pension provider will let you know if you are going to trigger a BCE. If you are unsure in advance, please ask.

Impact of the LTA

When members take benefits from registered pension schemes (crystallise benefits), they use up a proportion of their LTA. If the individual takes more benefits later, the additional benefits are tested against the remaining proportion of the member's LTA.

Simple Example

Mark takes benefits with a value of £500,000 when the standard lifetime allowance is £1.8m. He then takes a further £500,000 when the standard lifetime allowance is £1.5m.

Mark would now like to know how much he can crystallise without incurring a lifetime allowance tax charge today. The table below shows how to calculate this. You can see Mark currently has a remaining LTA of £417,317 from the available £1,073,100.

When you take the benefits and what the LTA was at the time matters. Also, if you took benefits before 2006, the calculations are different. So too is the way in which you calculate benefits taken from Final Salary pensions (essentially, 20 times the income plus tax free cash; unless it was also before 2006, when it is different again). In short, each BCE has a set formula to calculate the capital value of the amount being crystallised.

When you take benefits, your pension provider will provide you with a certificate that expresses LTA used as a percentage. Once you exceed 100%, you are liable to the LTA tax.

Lifetime Allowance Tax

The Scheme Administrator (most likely your pension provider) must check the amount crystallising each time there is a BCE to ensure that the appropriate tax is paid on any funds taken above the LTA. They must calculate the capital value of the benefits coming into payment, to verify the percentage of the LTA being used. As discussed above, the method of doing this depends on the BCE.

If the percentage of the LTA crystallising is greater than the percentage available, the excess becomes a 'Chargeable amount' and the ‘LTA tax’ is applicable.

The tax rate depends on how the excess is paid.

The first and the one most people are familiar with, is when the excess is paid as a lump sum and is taxed at 55%.

The other, if the excess is retained to pay pension benefits, is taxed at 25% (tax is then payable on the income the member receives at their marginal rates). This is one of the key planning points which we will cover in the first strategy below.

Reducing The LTA Tax

There are three strategies I use to reduce the overall LTA tax chargeable:

• Utilise the Pension Benefits 25% tax instead of Lump Sum 55% tax

• Providing For Future Generations

• Use Other Wrappers To Reduce Your Overall Exposure

I will provide one simple example for each. Used together they can be manipulated to reduce the effect of the LTA tax substantially.

Lump Sum v Pension Benefits

If we consider someone with a pension fund of £1,273,100, so £200,000 over the current LTA.

The default action the industry has seen is for the member to crystallise their entire pension fund as soon as possible…which currently would be their 55th birthday.

The member typically takes 25% tax free cash from the LTA (so currently 25% of £1,073,100) with the remainder (75% of the LTA) moving into income drawdown.

The excess, £200,000 in this case, is then normally taken as a lump sum. 55% tax is paid (£110,000), leaving the member with £90,000 outside of pensions.

The alternative I would suggest is to leave the excess to provide future pension benefits.

The £200,000 is instead taxed at 25% and the net £150,000 remains invested inside pensions.

Let’s fast forward 5 years.

The £150,000 has remained invested (tax free) and assume it has grown back to the original £200,000.

The member now retires (age 60) with no other source of income (a not unreasonable assumption as most couples will be able to manipulate income in retirement before drawing the state pension).

They could then draw £50,000 a year from this excess pension pot for 4 years*. Since this amount drawn is taxed at their then marginal rate, the tax paid on each £50,000 would be just £7,486, so a little shy of £30,000 over the 4 years. (This assumes the personal allowance remains at £12,500 and the basic rate income band remains at £37,500.)

The net cash paid out of the original £200,000 is £170,000…a net effective tax rate of 15%. Substantially less than the £110,000, 55% at outset and a 41.67% net^ increase in capital out of the excess funds.

^ For comparison purposes, the £90,000 withdrawn could also have been invested and would have grown to £120,000 using the same growth rates.

* At this point I have assumed no further growth, just to make the numbers easier. The reality is that after year 1, the remaining £150,000 is still invested and can continue to grow tax free.

Providing For Future Generations

Many lucky enough to have accrued funds above the LTA don’t always need the funds to provide for their retirement. They have significant other assets and are also often concerned about inheritance tax.

Using the same scenario above, someone with a pension fund £200,000 over the current LTA.

We have seen the default route, £90,000 net after paying 55%. This amount is now in their estate and taxable at 40% on their death.*

The alternative is that the 25% is paid and the £150,000 remains invested.

This time, fast forward 20 years and assume 5% growth.

The £90,000 is now worth £238,000^ and the £150,000 is worth £397,500.

On death, the £238,000 is taxed at 40% and becomes £142,800.

The £397,000 is still in pensions where it would be paid out to beneficiaries as an income. Even 40% taxpayers would net £238,000, 67% more. 123% if they are basic rate taxpayer, and even greater savings if personal allowances can be used as above, if for example the beneficiaries are multiple grandchildren.

* I am assuming, since they are concerned about IHT, their estate is well in excess of any allowances and therefore this £90,000 just goes on top on their existing assets and will be taxed accordingly.

^ It is likely the funds outside of the pension would grow at a lower rate as they are subject to taxes but for simplicity we will ignore this…plus it only makes the case stronger for the 25% route.

Using Other Tax Wrappers

The chances are if you have built up a decent sized pension fund then you may well also have sensibly invested in ISAs.

This time, someone who has not yet reached the LTA.

This person is 50 and has £800,000 in pensions and £200,000 in ISAs.

Most people retain a consistent asset allocation across all investments. Let’s assume a balanced investor investing 50% in equities and 50% in fixed interest. Let’s also assume growth rates on equities are 8% over the long term and 2% on fixed interest, so an average 5% for a 50/50 allocation*. This keeps things consistent with the examples above which assumed a 5% growth on the pension.

This person will exceed the current LTA not long after 6 years at which point, they may well consider crystallising benefits to prevent excess taxes.

If we assume they take the benefits in year 7, when the pension is £1,125,000 and pay the 55% tax. That’s a tax charge of some £28,500.

If on the other hand we simply altered the asset allocation of each tax wrapper without changing the overall risk of the portfolio.

The ISA would move the 100% equities. This is because there is no limit on what the ISA can grow to and equities over the long term should provide higher returns. ^

To keep the overall asset allocation at 50% equities, the pension should move to 37.5% equities. At the same point in year 7, the pension fund is still under the LTA but the overall value of the pension and ISA is the same.

A £28,500 saved by doing a bit of Tetris.

Bigger savings can be achieved if we also take account of pensions and investments held in a spouse’s name. Usually one partner has the larger pension fund. If we take the same approach, the partner with the smaller pension fund would invest 100% in equities, keeping the family risk the same. The savings would then just keep adding up.

* I understand this is a simplistic approach, but that’s the point. In this example, the pension allocation would need to be rebalanced annually in order to retain the same allocation.

^ Past performance is no guide to future returns etc

The Future of the Lifetime Allowance

Since 2018 the LTA had been index linked and was due to increase gradually over time. LTA increases between 2021/22 to 2025/26 have been frozen and it would not be a stretch to consider this is the end of the increases and even a slide back down to the round £1m could be likely, with further reductions not to be ruled out.

As you can see, the interaction between the LTA and the resultant tax has many nuances and if you want to be sure your pension funds are maximised for the benefit of you and your family then speak with us for an LTA Healthcheck.