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How can I mitigate a high lifetime allowance charge?

A reader asks how best to minimise the lifetime allowance charge
How can I mitigate a high lifetime allowance charge?

I have just turned 72 (my wife is 73) and have a good sized self invested personal pension (Sipp) of nearly £4.4mn, on which a significant lifetime allowance charge (LAC) is due at age 75. I currently estimate that it is over £700,000 – ouch! And although I have started drawing down my Sipp, I expect the fund will continue to grow. So the LAC could eventually be over £1mn. Are there any legitimate ‘technical’ steps to mitigate the LAC?

Conventional wisdom suggests drawing down individual savings accounts (Isas) (ours are worth over £800,000) before Sipps, given the favourable inheritance tax (IHT) treatment Sipps receive (at least for now). But if we do that, wouldn’t it increase the LAC because the Sipp ends up bigger than it otherwise would be? What’s the best trade off here?

We have set up but not yet funded a discretionary trust mainly for the benefit of disabled relatives. Should we transfer cash out of the Sipp (taking the income tax hit) before the LAC is due, to fund the trust?

Should we have different investment strategies (maybe higher risk versus lower risk) before and after age 75, when the LAC is payable? More broadly, how do plans to mitigate any LAC fit in with plans to mitigate IHT on our eventual deaths.

Robet Pullen, partner at tax and advisory firm Blick Rothenberg, says:

Age 75 is a lifetime allowance 'event', acting as a form of sweeping-up exercise to make sure that any previously untouched pension funds are tested against the lifetime allowance (LTA). Pension funds in drawdown are included in the at-75 test, but only to the extent that the drawdown fund has not been tested against the LTA before. For example, if tax-free cash of £250,000 is taken from a pension fund of £1mn at age 60, £750,000 being designated to flexible access drawdown, and the value of the drawdown fund at age 75 has grown to £1.3mn, the amount subject to the at-75 LTA test is £550,000.

To the extent that the amount tested at age 75 is in excess of any LTA still available, it is subject to a LAC of 25 per cent. In our example, should there be no LTA available, the LAC would be £137,500, paid from the drawdown fund, leaving £1,162,500.

From your own figures and a current estimated LAC of £700,000, we might infer an excess of £2.8mn and, so, an original drawdown fund, post lump sum, of £1.6mn.

There will be no LTA excess/LAC at age 75 if the value of the drawdown fund is no more than it was when tax-free cash was first taken. That can be achieved by simply drawing off any increase before your 75th birthday. Of course, such withdrawals are taxed as your income. If it is only a matter of time before you draw the income and pay tax on it, it makes sense for you to draw as much as you need before age 75.

The situation is less clear cut if you have no personal need of more pension income meaning that the pension funds are more likely to outlive you. Certainly, as you seem to be aware, if you die before age 75, your drawdown fund is not tested against the LTA (not even the drawdown fund growth that is tested at 75) and your successors can expect to draw on their inherited pension funds tax-free.

If you die at or after age 75, your successors will pay income tax on their own subsequent withdrawals. Experience shows that, in certain circumstances, it can be more beneficial for your successors – especially non or basic-rate taxpayers – to allow your pension fund to bear the at-75 LAC, galling though that may be.

Equally galling, perhaps, is that the Treasury gets to share 25 per cent of any successful investment strategy over the next three years. That might tip your 'risk/reward' assessment in favour of lower risk investments, but it is not necessarily rational to focus on the pension funds in isolation. It would require careful thought, and you would need to take appropriate independent financial advice from a regulated adviser.  

Your pension funds might be passed on in two ways, potential beneficiaries being both family members and a vulnerable persons’ trust:

  • You take income withdrawals, subject to income tax, and gift the net proceeds to individuals and/or the trust;
  • You nominate (in writing, to the pension provider) that you would like named individuals and/or the trust to benefit from your pension fund on death.

A trust can only receive a lump sum from your pension fund. If you die before age 75, the trustees would receive the lump sum tax free. And if you die at or after age 75, the lump sum is subject to income tax at the trustees’ rate of 45 per cent. The tax paid by the trustees is available as a credit on any subsequent distributions of capital paid to beneficiaries of the trust.

The interaction between managing your LTA excess/LAC is intricate, and there is not a 'one size fits all' answer. Usually the best approach is to work out your personal balance sheet position, by adding up all your assets and calculating what IHT is due depending on how your will has been drafted.

You can then devise a plan to mitigate IHT. This might include giving away assets in lifetime or taking advantage of particular reliefs.

One relief which could be helpful to you is the 'gifts out of excess income' exemption. Usually, when you gift an asset or value to another individual, the gift remains in your estate and is exposed to IHT if you pass away within seven years. Where the gift qualifies as a gift out of excess income, it is immediately exempt, saving an immediate 40 per cent IHT charge. This relief could also be used as part of the disabled trust planning (although an IHT exemption applies usually for such funding, this only applies where the settlor/donor survives seven years).

There are conditions to this relief and further guidance can be found at https://www.gov.uk/hmrc-internal-manuals/inheritance-tax-manual/ihtm14231