By Nick Gwilliam Dip PFS, Founding Financial Adviser, Integrity365, a Beavis Morgan group company.
What is the Lifetime Allowance?
With pension planning, it’s important to understand how the Lifetime Allowance can play a part in your financial planning to help you reach your financial goals and provide maximum benefits for you and your family.
The Lifetime Allowance is the maximum value of pensions an individual can accrue before a penal tax charge (the Lifetime Allowance Charge) applies. The Lifetime Allowance has fallen from a peak of £1,800,000 to £1,073,100 currently, where it will remain frozen until April 2026.
With pension planning, there are many options to consider based on your own individual circumstances. It’s important to understand how the Lifetime Allowance can play a part in your financial planning to help you reach your financial goals and provide maximum benefits for you and your family. In order to further explain how this may work, please take a look at the case study below.
Sue is 59, three months from retirement, and has approached an Independent Financial Adviser to review her current pension plan. She has always assumed she would take the tax-free cash lump sum from the pension when she retires, but has no plans for the money. Sue has also heard about the potential for pensions to be used for the benefit of her family, however, does not know how this works or where to start.
Over the past few years, Sue has worked as a Director of a consultancy business and has amassed a pension fund with a value of £1,000,000. During discussions with her adviser, she also mentioned she had an old local government final salary pension which will pay her an income of £12,500 from age 60.
How close is Sue to the Lifetime Allowance?
When benefits are taken from a pension, they use a percentage of the lifetime allowance, rather than the monetary amount. This is because changes in the lifetime allowance can then be reflected when further benefits are taken.
Sue’s personal pension is worth £1,000,000 but she also has the local government pension of £12,500. For the purposes of the lifetime allowance, the local government pension is valued at 20 times the annual income (and not the transfer value). Therefore, this pension is valued at £250,000 (20 x £12,500) and will use 23.3% of her lifetime allowance (£1,073,100). This will leave her 76.7% of her lifetime allowance, meaning that, if her personal pension is valued at more than £823,100, she may face a lifetime allowance charge on the excess.
Lifetime allowance = £1,073,100
Government Pension Value = 20 x £12,500 (annual income) = £250,000
Lifetime allowance remaining after government pension = £1,073,100 – £250,000 = £823,100
How is the Lifetime Allowance charge applied?
Sue’s personal pension is worth £1,000,000, which means if she were to take the maximum lump sum at retirement as planned, her pension would exceed her available lifetime allowance by £176,900 (Lifetime Allowance (£1,073,000) – Personal Pension (£1,000,000) – Government Pension (£250,000) = -£176,900) . She has two options; she could take the excess as a lump sum, less a 55% lifetime allowance charge of £97,295. Alternatively, she could designate the excess to provide an income which reduces the charge to 25%, or £44,225. Any income she then draws will be subject to income tax at her marginal rate.
Should Sue take her tax-free lump sum when she retires?
Sue’s tax-free lump sum is limited by her available lifetime allowance. An individual can take 25% of their pension tax-free lump sum, up to their remaining lifetime allowance. Sue had assumed she could take 25% of her personal pension as a tax-free lump sum, which would be £250,000. However, if she takes the local government pension first, Sue’s maximum tax-free lump sum from her personal pension will be £205,775 which is 25% of her available lifetime allowance of £823,100.
However, as Sue has no plans for the money, her adviser has recommended that she does not take this lump sum for the following three reasons:
If she takes the maximum lump sum, she will use 100% of her lifetime allowance, and so if the Pension Lifetime Allowance goes up in the future she will not benefit from the increases.
The tax-free lump sum could be paid in smaller amounts over a number of years and used to supplement income from the pension. In the early years this will reduce the amount she needs to take from her pension to meet her expenditure
The tax-free lump sum will be paid to her estate, and if it is not spent may be subject to Inheritance Tax depending on the value of her other assets. Pensions on the other hand are not usually subject to inheritance tax.
Can Sue do anything to avoid a lifetime allowance charge?
If Sue has not made a pension contribution since April 2016, she can apply for a lifetime allowance of £1,250,000. However, if she has but the value of her pension funds were worth more than £1,000,000 in April 2016, she could claim a lifetime allowance equal to the value of pension fund to a maximum of £1,250,000. In order to calculate this, Sue would need to contact the local government pension to establish her income entitlement as at 5th April 2016, using the 20 times multiple to calculate the value, and add this to the value of her personal pension at the same date.
If the legislation remains as it is, and Sue cannot obtain a higher lifetime allowance, she will most likely face a lifetime allowance charge at some stage. She can, however, try to limit the charge, using one or more of the following strategies:
Reduce the investment risk, and thus the potential growth, in her pension and increase risk in her non-pension assets, ensuring her overall wealth is in line with her attitude to risk.
The pension fund is only tested against the lifetime allowance when benefits are taken e.g. if Sue “crystallised” £50,000 of her pension when she retires, she would use 4.7% of the lifetime allowance. The longer she can avoid crystallising all of her lifetime allowance, the more she will benefit from any increases to the lifetime allowance.
A final test on any pension funds takes place at age 75, and this includes drawdown funds which are effectively being tested for the second time. To mitigate the charge on any drawdown funds she could draw an income from these funds, although she would need to balance the income tax paid versus the potential lifetime allowance charges.
How can Sue’s family benefit from her personal pension?
Depending on how have set out your Expression of Wishes with your pension provider, you can nominate a beneficiary to receive death benefits of your pension when you pass away. In Sue’s case, her adviser first recommends that she reviews this to ensure that the relevant family members will benefit from her pension in the event of her death.
If Sue were to die before the age of 75, any personal pension fund remaining would pass to her beneficiaries tax-free, after the payment of any lifetime allowance charges. They could either leave the balance of the funds in the pension to continue to grow tax-free, drawing as they need it, or take the full amount out as a lump sum.
However, if Sue dies after the age of 75, her beneficiaries could still draw from their share of the pension fund, but any withdrawals will be subject to income tax. As benefits would have been tested at age 75, no further lifetime allowance charges apply on death after age 75.
Pensions are not usually subject to Inheritance Tax, and so can be used for estate planning purposes. When establishing her income requirements in retirement, Sue should be considering not just her pensions, but also her non-pension assets to produce the income. In Sue’s case, she is working with her Independent Financial Adviser with an aim to avoid an exposure to the lifetime allowance and striking a balance between meeting her income needs as well as providing benefits for her family.
Sue’s adviser points out that using pensions as your only estate planning option could be detrimental to your end goals. In the past 15-years, we have seen the rates of tax applied to pension death benefits as 0%, 35%, 55%, up to 82%, and more recently, the beneficiary’s marginal rate of income tax. Therefore, at various times the rate of tax has been higher than the rate of Inheritance Tax, and so relying on pensions in isolation to maximise the amount your family receive is unlikely to be robust in the long term.
Therefore, Sue agrees with her adviser’s suggestion to undertake a full cash flow planning analysis which will help her to understand the best course of action when she retires.
As you can see from the above case study, financial planning is a complex area and there is no one-size-fits-all approach. This case study should not be taken as advice, it is for information purposes only. Gaining the right advice from a trusted Independent Financial Adviser is key in order to devise a strategy that focuses on your own circumstances and goals in order to maximise the benefits for you and your family.
For more information, contact Neal Groves, Head of Personal Tax at Beavis Morgan, who will discuss your situation and put you in touch the an adviser at Integrity365 who will advise of the best course of action for you.