Avoiding the Pension Lifetime Allowance Test at age 75

Firstly, a big thank you to all of you who got in touch about my last article, which was about investments that come with sumptuously appetising brochures but whose underlying charges are not so digestible. Please bear with us if we haven’t as yet been able to answer your queries in full. Providing an analysis of your investments and pensions is time-consuming, as you might imagine. 

One of the more complex financial planning areas is the pension lifetime allowance (LTA). Even though you may be retired and receiving your pension, you are still subject to the LTA test at age 75. The lifetime allowance tax charge can be significant, so it’s important to take it into account in your planning. Using the appropriate strategy can help minimise the impact of exceeding the allowance.

The LTA was introduced on the 6th April 2006 and the original allowance was £1.5 million. By the 6th April 2011 this had risen to £1.8 million. It has since been significantly reduced however.  The current allowance as at March 2021 is £1,073,100. Having been increased by inflation over the last few years it will now remain at this level until the 2025/26 tax year. Some have described this a stealth tax by the way.

The LTA is the total amount you can hold in pensions without facing the LTA tax charge.  The allowance does not apply to the State Pension but does include all other pensions.  

To see how you are affected by the LTA: 

  • Add up the value of all of your money purchase pensions, whether personal pension policies or occupational schemes.  
  • For final salary pensions take the projected income per annum and multiply it by 20 and then add in any lump sums. Then add this value to your other pension funds.

If you find the combined value of all your pensions is above the current LTA then you don’t face a tax charge straight away. You only face a potential tax charge at the point you decide to take money out of your pension arrangements. At that point a test is carried out to see if you have exceeded the limit. The test is only done on the funds used to create your withdrawal. 

So, if for example you have a personal pension worth £800,000 and you want to take out £200,000 as tax-free cash to help one of your children buy their first property, you would need to crystallise the whole of the policy. After taking out the £200,000 the remaining £600,000 could be left invested in an income drawdown policy, if you don’t need income immediately. The crystallisation amount of £800,000 is below the LTA of £1,073,100, so no tax charge is applicable. You would need to remember however that 74.55% of your LTA has now been used, and that if you have other pension funds building up, you will have 24.45% of the LTA remaining when you come to crystallise them.

The above example is deliberately straightforward. If however you are receiving, to give a different example, a final salary pension of £50,000 per annum and you also have personal pensions, the calculations become more complex. The final salary benefits multiplied by 20 mean you are using £1m of your allowance and your personal pension benefits are potentially going to take you over the LTA limit. Red light! You are now entering a minefield! In this scenario specialist pension advice is absolutely essential. 

Then at age 75 there is a further LTA test applied. If the growth on your drawdown fund exceeds the remaining allowance, you will pay a further tax charge. There are however various ways you can mitigate the effects of the LTA.

For drawdown policies you could consider applying to HMRC for either Individual Protection 2016 or Fixed Protection 2016 depending on your circumstances. The decision as to which one to choose has to be take in the context of your overall objectives and circumstances. It is certainly best to seek professional advice in this area also.

It might seem logical as an additional strategy to pursue a conservative investment strategy to keep your fund within the LTA. This could be self-defeating however, as even with more investment growth and a higher tax charge, your net position is likely to be more advantageous. If your employer is making pension contributions on your behalf and you are aware of LTA issues, it should not keep you awake at night for this very reason. It is after all free money that will end up in your bank account, albeit reduced by the tax charge!

Finally you could withdraw income to put a brake on fund growth. You do need to bear in mind that such income is almost certainly going to be taxable. It could also have a bearing on your inheritance tax planning, as your pension funds are a highly tax efficient means of transferring wealth down the generations. This may or not be an issue.

To enable a proper pensions review, we would need as a minimum the following information from you as a starting point:  

  1. How much income you require
  2. A working assumption of for how long

As advisers we can help you understand your LTA position, where you stand and what you need to do next.   We can then ensure inflation is taken into account and develop a strategy for drawdown. Please do feel free to get in touch, if you think we can be of use.

Joe Coten is a member of the Personal Finance Society. He may be reached on 0207 588 9626.