Three ways investors can gain the upper hand over the controversial Lifetime Allowance.
The Lifetime Allowance (LTA) has caused its fair share of controversy over the last few years. In a nutshell, the LTA is the limit on the amount of pension benefit that can be drawn from pension schemes, whether that be a lump sum or retirement income, before you trigger an extra tax charge.
It’s been controversial because since 2012, when the LTA stood at £1.8 million, the government has steadily reduced the limit. From next April it rises from £1.03 million to £1.055 million, increasing in line with CPI inflation. But the net has been widened considerably by several years of progressive reduction, trapping many more retirees than previously. Understandably, it is viewed by many as a tax raid on pensions.
Many people wrongly assume the LTA will never apply to them. They brush it aside, as they assume only the super-wealthy would have £1 million in their pension pot. But that’s not necessarily the case.
Broadly speaking, the LTA is only tested before someone is 75, if they take money from their pension or if they pass away. If the total value of their benefits exceeds their lifetime allowance, they need to pay the lifetime allowance tax charge on the excess. The tax they pay will depend on how they take the money out; if they take it as a lump sum they will be taxed at 55%, and if they take it as income, either as drawdown or by purchasing an annuity, they’ll be taxed at 25%.
If you are getting close to the LTA, there is some action you can take to protect your money. Here we look at how even those on mainstream salary levels can be caught, and what they can do to mitigate it.
1. Consider getting protection
Protecting your pension savings is a tried and tested way of minimising the effects of the LTA. There are two different types of protection you can apply for – either Fixed Protection 2016 or Individual Protection 2016. Fixed protection fixes your LTA at £1.25 million. However, one of its stipulations is that you cannot have made a pension contribution since April 2016, which rules out most people who have been ‘auto-enrolled’ into a company pension scheme.
Individual Protection 2016 protects your lifetime allowance to whichever is lower, either the value of your pension savings as of 5 April 2016, or £1.25 million. Although you can continue to contribute to a pension with Individual Protection 2016, it is only worthwhile if your pensions were valued at more than £1.03 million in April 2016, again ruling a fair number of individuals out.
2. Consider taking your tax-free lump sum
One way to reduce the value of your pension is by taking advantage of the 25% tax-free lump sum, as growth that would have been attributed to this sum will not be subject to the LTA. For instance, if you are 55 with a pension worth £1,000,000, if the funds are not being drawn and are growing at a rate greater than inflation, it is very likely that there will be a lifetime allowance charge at age 75.
But if you withdraw £250,000 from the pot and invest this elsewhere, then any growth on this element will not be subject to the Lifetime Allowance at age 75, whereas previously it would have. But you have to remember that any funds taken from your pension could form part of your estate for inheritance tax purposes.
3. Draw an income from your pension
There are lots of things to think about when considering this, in particular your income tax position and the money purchase annual allowance. But in some circumstances, you could tactically draw an income from your pension to keep your pension fund below the threshold.
If the income is not needed, you could even go a step further and fund your children’s pensions with the proceeds, to balance any income tax you might have paid. Alternatively, the income could be used to fund a whole of life policy that pays out a lump sum outside your estate on your death, which could be used towards your IHT liability.
In conclusion, there is little doubt the government needs to rethink its pension strategy and consider the repercussions of the cuts it has made to the Lifetime Allowance. But until this happens, people are strongly advised to seek professional help to guide them through the pensions minefield.
Sagar Morjaria is a wealth adviser at Canaccord Genuity Wealth Management.