Retirement Planning and the Lifetime Allowance

The Lifetime Allowance sets a limit on the amount of pension savings that an individual can accrue within their lifetime whilst enjoying the full tax benefits.  The lifetime allowance has seen significant increases and decreases since its introduction in 2006 but it is currently £1,073,100 and set to remain at this level until April 2026. The client isn’t penalised at the point that their benefits or savings exceed the lifetime allowance but at the point the amount crystallised exceeds 100% of their lifetime allowance. This means that for many the actual point of exceeding the allowance, and paying tax charges, can be successfully deferred for many years and for many until age 75 when any remaining untested benefits will be caught.

Timing of the LTA tests

As mentioned above the lifetime allowance is only tested at the point you crystallise benefits (benefit crystallisation events BCE). This is where a little planning can really help maximise benefits and reduce the impact of any lifetime allowance charge.

The first thing to remember is that whenever benefits are crystallised BCE 6 (relevant lump sum) happens first, this is to ensure that there is sufficient lifetime allowance to pay a pension commencement lump sum (PCLS), although this also covers UFPLS. If PCLS then it will immediately be followed by BCE 1 (drawdown), BCE 2 (scheme pension) or BCE 4 (annuity).

The client can decide what and how much is crystallised at any one point. For example, crystallising benefits from a defined benefit pension scheme will mean the whole pension is likely to be tested in one go as it is rare to be able to phase a defined benefit scheme. However, a defined contribution scheme can often be phased only crystallising the required amount for the year.  This will result in the deferral of any applicable lifetime allowance charge, as well as not bringing excess PCLS into the client’s estate.

In an ideal world you would test defined benefit pensions first, pushing a lifetime allowance charge onto defined contribution schemes, this protects the valuable guaranteed benefits which are usually also inflation proofed to some extent. This isn’t of course always possible, because many clients want to access their defined contribution schemes first to avoid an early retirement penalty, but again this means that thinking about how much to crystallise and when is very important.

The Charge

Funds in excess of the lifetime allowance can either be drawn out as a lump sum or retained in the pension to provide an income. Where the excess is paid as a lump sum the charge is 55%.  Where the excess is used to provide an income the charge is 25%.  The lifetime allowance charge that is applicable reflects the fact that where the funds are retained to provide an income they will, in theory, eventually be subject to income tax when drawn.

LTA on Death

The lifetime allowance test on death is also an important thing to consider. It should only apply to those that die before the age of 75. This is particularly important because any lifetime allowance charge will fall onto the beneficiary, not paid directly by the scheme. It is also not possible to choose the order of the benefit crystallisation events meaning that if there is a lifetime allowance excess and multiple beneficiaries, all the beneficiaries will be subject to some charge. The fact that the charge should only occur before the age of 75 should mean that in most cases the beneficiary should have access to the benefits to pay the charge and the amount they need to draw in order to pay the charge will not be subject to income tax.

The remaining lifetime allowance is allocated proportionally to each of the beneficiaries based on the amount of benefit they are inheriting, and the applicable charge is the calculated. This again means that you can’t give all the lifetime allowance to those that would be subject to a 55% charge (lump sum death benefits) over those who will be able to access benefits as income and only pay the 25% charge.  

Where clients are likely to be subject to a lifetime allowance on death, the income option is clearly far more favourable, and this option should be considered for the beneficiaries wherever it is possible. 

Deliberately breaching the LTA

We should always remember the LTA is an allowance and not a limit and so it can legitimately be breached if you are prepared to pay the tax on the excesses. In most cases it makes sense to cease contributions before the client is going to be subject to an LTA charge, but this isn’t always the case.

If the client would otherwise lose the contributions that would push them over the LTA is one case where it can still make sense. Not all employers are flexible with remuneration and even if they are then additional deductions such as national insurance can still make employer pension contributions attractive.

Other circumstances may be where the client within the band of earnings that results in the loss of the personal allowance, in this case contributions will attract more effective relief than the LTA charge recoups.

In addition, the inheritance tax benefits can still be an attraction where the client has used all other means to legitimately reduce their estate for IHT. 

Protections

As mentioned earlier the current lifetime allowance is £1,073,100 but it has been as high as £1.8m. The introduction and the drop in the lifetime allowance have led to a raft of protections, all of which are closed except the 2016 versions. Looking at each of them at a high level we have:

  • Enhanced protection – offering unlimited lifetime allowance, although can be lost/revoked if contributions are paid or relevant benefit accrual occurs after 5th April 2006
  • Primary protection – offers a multiple of the standard lifetime allowance, £1.8m if higher. The amount was determined by the level of benefits held on 5th April 2006, generally can only be lost in cases of pension sharing
  • Fixed Protection – Fixed lifetime allowance of £1.8m, lost if lost/revoked if contributions are paid or benefit accrual occurs after 5th April 2012
  • Fixed Protection 2014 – Fixed lifetime allowance of £1.5m, lost if lost/revoked if contributions are paid or benefit accrual occurs after 5th April 2014
  • Individual Protection 2014 – Fixed lifetime allowance of between £1.25m and £1.5m, determined by the value of benefits held on 5th April 2014, generally only possible to lose in cases of pension sharing
  • Fixed Protection 2016 – Fixed lifetime allowance of £1.25m, lost if lost/revoked if contributions are paid or benefit accrual occurs after 5th April 2016
  • Individual Protection 2016 – Fixed lifetime allowance of between £1m and £1.25m, determined by the value of benefits held on 5th April 2016, generally only possible to lose in cases of pension sharing

Enhanced and primary protection also offered enhanced tax-free cash if the amount the client was entitled to was over £375,000 on 5th April 2006. For enhanced this is a percentage of total funds crystalised with no limit. For primary this is a monetary amount indexed in line with the changes in the lifetime allowance.

Conclusion

The LTA is something that shouldn’t be feared or avoided but managed. This doesn’t mean that investment strategies should be changed to reduce growth, but that timing and way in which benefits are access should be carefully considered to take account of all the implications, including income tax, inheritance tax as well as the LTA charge. 

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