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What to do when your pension hits the LTA

If the value of your pension exceeds the lifetime allowance you may have to pay a charge
What to do when your pension hits the LTA
  • Increasing numbers of pensions' values are breaching the lifetime allowance
  • You can apply for lifetime allowance protection in certain circumstances
  • It can still be worth contributing to pensions even if this means their value exceeds the lifetime allowance

I recently asked do-it-yourself (DIY) investment platforms what their customers' most common questions on self-invested personal pensions (Sipps) are. And one of the most common subjects was how to manage the pensions Lifetime Allowance (LTA) – despite this only affecting a relatively small number of pension savers.

This may be because increasing numbers of pension pots' values are exceeding the LTA – the amount you can build up in them without having to pay a penalty charge. This is because the pensions LTA has been reduced over the past decade from a peak of £1.8mn in 2012 and the current level of £1,073,100 is frozen until 2026.

 

How does the pension LTA work?

You do not pay LTA charges until you have drawn an amount worth the LTA limit of £1,073,100 from your pension. Your pension is tested against your available LTA when what’s called a ‘benefit crystallisation event’ occurs. The main ones are when you draw from a pension, reach age 75 and die. You can see the full list of benefit crystallisation events at https://www.gov.uk/hmrc-internal-manuals/pensions-tax-manual/ptm088100#IDAX15K.

If you have multiple pension pots, you will trigger a benefit crystallisation event each time you access a new pension pot and receive a certificate stating how much of your benefit crystallisation event you have used up. To complete a benefit crystallisation event, your pension provider will ask you to make a ‘pension benefit application’ which asks which other pensions have been accessed. If you have external pensions, the provider of the pension from which you are withdrawing will ask to see other providers' LTA certificates, so keep these safe. 

When you have used up your LTA, any further pension crystallisations trigger a charge of which the amount depends on how you make the withdrawal. If you take the money from the pension as a lump sum it is taxed at 55 per cent and if you take it as income it is taxed at 25 per cent. The difference is because the 55 per cent charge on the lump sum is the only tax payable, whereas if you take it as income you pay income tax at your marginal rate on top of the 25 per cent charge.  

Gary Smith, chartered financial planner at Tilney Smith & Williamson, gives an example. “If an individual had a pension fund of £1.5m and they moved £536,550 into drawdown, this would use up 50 per cent of the standard LTA. If they moved a further sum of £268,275 into drawdown two years later, this would use up 25 per cent of the LTA, meaning they had then used up 75 per cent. If, after a further five years, they moved £500,000 into drawdown, £268,275 of this would fall within their remaining LTA with an excess of £231,725 being subject to a tax charge.”

If you are in a defined benefit (DB) pension scheme, the value of your pension is calculated as 20 times your starting pension income plus any lump sum paid to you from the scheme. The LTA is the same regardless of whether you have DB or DC pensions, or a combination of the two. 

 

Test at age 75

When you reach age 75, any pension funds which you have not crystallised are automatically tested against your LTA by your pension scheme administrator. And any funds in drawdown are tested for a second time at age 75, with any growth tested against the LTA. 

“The value of the funds at age 75 are compared to the original amount designated into drawdown minus any Pension Commencement Lump Sum,” explains Rebecca Pratt, financial planner at Brewin Dolphin. “The difference between the two figures is what is deemed to be crystallised at age 75 and tested against the available LTA.”  

If the test at 75 leaves you with insufficient LTA, a charge of 25 per cent is applied to the excess. Pratt adds that the 55 per cent lump sum charge is not an option at 75 but there is no obligation to bring your pension into payment at that age. So it may be possible to defer taking benefits although this depends on your pension scheme's rules. 

Your pension providers will send you a reminder six months before you are age 75 with a test form to complete and return, outlining all the pensions you have accessed and when.

"This is why I’m a big believer in consolidating pensions where possible,” says Daniel Hough, financial planner at Brewin Dolphin. “The age 75 test needs to be completed [by three months after your] 75th birthday, so effectively a nine-month window.”

If you die before 75, your LTA is tested at the time of your death. If you live past age 75 there are no further LTA tests except in a few instances with DB schemes.

 

LTA Protection

Pension savers can apply for LTA protection using either Individual Protection (IP) 2016 or Fixed Protection (FP) 2016 which provide LTA protection of up to £1.25mn. 

You can apply for IP 2016 if you had a fund worth at least £1mn on 5 April 2016. This allows you and your employer to continue contributing to pensions so it is a particularly attractive option for employees in DB schemes.

FP 2016 is available to those who have not made contributions to their pension since 6 April 2016. It also offers £1.25mn of protection, even if your pensions' value was below £1mn on 5 April 2016. But you cannot make any more contributions to your pensions after taking out this protection or you lose it. Martin Reynard, senior pensions manager at Blick Rothenberg, cautions that pensions auto enrolment catches some people out, leading to a loss of fixed protection.  

 

How can I reduce my LTA charge?

If you are approaching age 75 and planning to take money as income, it might be worth accelerating your withdrawals if the money in your drawdown account has grown as this will lower the amount of your pension that is tested against the LTA. If the sum of your pensions is over the LTA, you could also change your pensions' asset allocation to subdue future growth and minimise the charges that you will have to pay. However, if you don’t want to access the money soon you could miss out on valuable future growth.  

Most pensions advisers think that you shouldn’t worry too much about LTA charges. Money invested in pensions grows tax free and the value of employer contributions could be greater than any LTA charges.

Pensions are also valuable vehicles for inheritance tax (IHT) planning as the assets within these do not form part of your estate for the purposes of this tax. And paying a 25 per cent LTA charge at 75 and then passing your pension onto beneficiaries IHT free is likely to be more efficient than these assets being outside a pension and subject to a 40 per cent IHT charge. If you die before age 75 the beneficiaries of your pension do not have to pay income tax when they access the assets within it, but if you die after 75 they pay tax at their marginal rates on withdrawals.