I was chatting with a friend recently who’s a member of a defined benefit pension scheme, and she announced she was likely to have to pay a lifetime allowance (LTA) charge due to a recent promotion.

    To avoid it, she’s considering either ceasing active membership or taking early retirement. Under the latter option, there’s an actuarial reduction, and her thinking was that when applied, it would significantly reduce any charge. In her eyes, the matter was further exacerbated by the freezing of the standard LTA (SLA) till the end of 2025/26 tax year.

    Generally, I find some people’s actions in attempting to mitigate the LTA charge somewhat perplexing, as my natural reaction has always been that it’s better to get at least 45% of something than 100% of nothing. I accept individual circumstance will be different, as will potential outcomes, but careful consideration needs to be given before any action is taken.

    Two choices

    In situations where an individual under age 75 is going to exceed their LTA when crystallising benefits, they have two possible choices. The first is to retain the excess within their pension, known as a retained amount, and on which there’s a tax charge at a rate of 25%. For example, if an individual with a Sipp crystallised £100,000 over their LTA and designated it to drawdown, the fund would be netted down to £75,000. Subsequent income taken from the drawdown fund would be subject to tax at their marginal rate of income tax.

    The other available option, if the scheme allows, is to take the excess over the LTA as a lifetime allowance excess lump sum with a tax charge at a rate of 55%. Using again, a £100,000 chargeable amount from a Sipp, the individual would have a net payment of £45,000 made.

    With the standard LTA now £1.0731m, some individuals finding themselves with an LTA issue may be just basic rate taxpayers or can manipulate their income to remain within the basic rate band. This being the case, with some judicious planning, the effective rate of tax on the excess, if drawn as income, could be just 40%.

    Despite this, headlines often fixate on the 55% charge, the natural reaction of which, for most people anyway, is to say I’m not prepared to pay that level of tax. Yet, I’ve come across situations where the individual, in trying to avoid an LTA charge by ceasing active membership of their scheme, has ended up paying tax at an effective rate of up to 60% through the loss of their personal allowance.

    If tax is the driver for a particular course of action, it’s essential to ensure a holistic approach is taken, and not just consideration of the obvious tax. For example, if we re-consider the lifetime allowance excess lump sum option, if the individual’s estate is also subject to IHT, then the £100,000 excess could have an overall tax rate of 73%.

    The following case study is based on an actual scenario where the individual, in attempting to avoid the possibility of an ever-increasing LTA charge, was considering taking the excess as a lump sum and investing it in an ISA.

    LTA

    ¹ No income or capital is taken from the ISA & pension fund remains uncrystallised with annualised investment returns of 5% for the ISA and pension, with 1% for holding the balance of the lump sum in cash until investment in the ISA. The ISA subscription each year is £20,000 with a balance of £11,634 paid in the final year.

    Worst-case scenario

    In the worse-case scenario, if Robert’s beneficiaries take everything as lump sum death benefits, assuming taxed fully at 45%, the inherited funds would still be £66,688 (63.6%) greater than the inherited ISA monies. If, however, the beneficiaries could extract income from the drawdown funds at 20%, after all taxes, the fund would be equivalent to £249,471 (assuming no further growth), or £144,648 (138%) more than from the ISA.

    Better still, if Robert had decided to jump a generation or even two, leaving funds to non-tax paying descendants, then money could potentially be extracted even more tax efficiently utilising the pension option.

    Knee-jerk reactions often lead to unintended negative outcomes, so when it comes to these types of scenarios, it’s imperative for individuals with such a dilemma to seek appropriate financial advice before making a final decision.

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