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What is the most tax-efficient way to manage the Lifetime Allowance?

This reader is looking for ways to mitigate LTA charges
What is the most tax-efficient way to manage the Lifetime Allowance?

I took voluntary redundancy about three years ago (I am now 67). I also transferred out of my defined-benefit (DB) pension, and the transfer-out valuation at £1.2m was just above the lifetime allowance (LTA) limit. Given I was only just over the limit and the LTA was due to increase with consumer price index (CPI) inflation I was not overly concerned about deciding the best way forward. However, with the LTA now frozen for five years I feel a need to make some plans and not to ignore the situation. At present, I have taken £200,000 into drawdown, and of the £50,000 tax-free lump sum £20,000 went back into an individual savings account (Isa). I am withdrawing a pension of £48,000 per year and the fund is currently valued at £1.4m.

My question is are there any tax-efficient ways to take funds out of the scheme to mitigate LTA charges other than moving all the funds into drawdown and taking the remaining tax-free money? JN

Kay Ingram, a chartered financial planner, replies:

First, let's look at what the LTA charge is. The LTA seeks to limit the tax advantages of pension savings for each individual currently at £1,073,100. These include:

  • tax relief on savings made at the saver’s highest income tax rate
  • tax-free growth and income while pension funds remain invested
  • 25 per cent of the fund, within the LTA, payable tax-free
  • exemption of pension savings left on death from inheritance tax and free of income tax if death occurs before age 75

Pension fund income paid out is subject to income tax and if cumulative funds are below the LTA this is the only tax payable. Where the cumulative funds paid out, and any remaining unused fund at age 75, or on earlier death, exceed the LTA, a one-off tax charge on the excess is payable. This is 55 per cent of the excess if taken as a lump sum or 25 per cent if taken as income, which may also be subject to income tax. After age 75 there is no further LTA charge. Thereafter its only relevance is to calculate any unused tax-free cash available.

The LTA, introduced in 2006 at £1.5m, rose to £1.8m in 2012, but was subsequently cut in 2014 and 2016 and is now frozen at £1,073,100 until 2026. This means that more pension savers are likely to exceed it. However, this should not be the tax tail that wags the retirement income dog when deciding how and when to withdraw income or cash from pensions.

In eight years' time, when you are 75, your pensions will be tested against the LTA for the last time. Thereafter, they offer unlimited tax-free growth and income within the pension pot with only income tax chargeable on withdrawals made.


Individual and Fixed Protection 16

There are ways your LTA may be increased. If, on 5 April 2016, your pension funds were over £1m you may qualify for Individual Protection 16. This provides a higher LTA based on the value of your UK private pensions accrued and in payment at that date up to a cap of £1.25m. DB pension scheme values are calculated at 20 times the annual pension accrued plus any additional tax-free cash (25 times for pensions that started payment before 5 April 2006). Defined-contribution (DC) schemes are calculated as the fund value. If the total is more than £1m Individual Protection 16 is available.

If the value of your pensions at 5 April 2016 were not over £1m, an LTA of £1.25m can still be obtained through Fixed Protection 16. Eligibility depends on no UK pension savings having been made since then and not being an active member of a DB scheme accruing benefits after 6 April 2016. Both forms of protection are accessed via the Government Gateway.


Holistic approach

When determining how to be most tax-efficient, consider all taxes that may be payable on all wealth, rather than in isolation. For example, tax-free 'income' can be generated by realising a capital gain within the tax-free annual allowance of £12,300. Your Isas could pay a tax-free income.

Withdrawing all the tax-free cash from your pension will not reduce the LTA charge. Based on the current fund value, you would trigger an immediate LTA charge. Any growth on funds that remain in drawdown will be reassessed against the LTA at age 75 or on earlier death.

Unless tax-free cash is spent immediately it will be taxed less favourably outside a pension wrapper than within it. Some may be invested in tax-efficient wrappers such as Isas or venture capital trusts, but will still be included in your taxable estate, whereas pensions are not. Saving 25 per cent tax to pay 40 per cent later is not a tax saving.

Spreading the tax-free cash over a longer period is likely to save more income tax than taking it in one lump. This is known as Uncrystallised Pension Fund Lump Sums (UFPLS), with 25 per cent of each payment tax-free and the rest taxed as income.

The £48,000 of annual drawdown income you are taking is taxed at 20 per cent. If future withdrawals included 25 per cent of this requirement as a tax-free lump sum each year you would save £2,400 a year income tax and be more likely to remain a basic-rate taxpayer. This could be better than paying no income tax at all when you withdraw all the tax-free cash but then having a bigger tax bill in later years.

Those who have not yet withdrawn more than the tax-free cash from their pension should be aware that starting UFPLS will trigger the lower annual allowance for pension savings of £4,000. So this option would not be suitable while intending to continue pension savings or in receipt of employer pension contributions.

When flexing withdrawals, be aware that HMRC will apply an emergency tax code to new withdrawals, which often means that too much tax is deducted at source. Overpaid tax may be reclaimed by completing forms P50Z, P53Z or P55 on the Government Gateway.

Pension freedoms allow flexible access to pension pots and generally taking only what you need to spend is most likely to promote a sustainable long-term income.