You usually pay tax if your pension pots are worth more than the lifetime allowance (LTA), which is currently £1,073,100 (Tax year 2020/2021) and which has increased annually by the Consumer Prices Index (CPI) since the 2018/19 tax year.
The Lifetime allowance is triggered when a member reaches age 75 or accesses their pension benefits.
When a member takes benefits from registered pension schemes (crystallise benefits), they use up a proportion of their LTA. If the individual takes more benefits later, the additional benefits are tested against the remaining proportion of the member’s LTA; this is always tested based on the percentage of a member’s remaining lifetime allowance. If the value of benefits exceeds 100% of the LTA, a lifetime allowance tax charge will be payable on the excess and there will be no further tax free cash lump sum available from excess benefits.
The rate of tax you pay on pension savings above your lifetime allowance depends on how the money is paid to you – the rates are:
- 55% if drawn as a lump sum;
- 25% if drawn any other way, for example pension payments or cash withdrawals.
What counts towards your lifetime allowance?
For defined contribution plans – i.e. personal, stakeholder and most workplace schemes – any money that is paid to you, however you decide to take the money, counts towards your lifetime allowance.
For defined benefit (final salary) schemes – i.e. some workplace schemes – it is usually 20 times the pension you get in the first year plus your lump sum, though you should check this with your pension provider.
Why is LTA planning important?
Since the LTA was reduced each year from the 2011/12 tax year through to the 2016/17 tax year it has begun to affect more clients, in particular for clients with pensions which began payment prior to 6th April 2006. This is due to the fact that pensions that were put into payment prior to 6th April 2006 are treated as having crystallised immediately prior to the client’s first post A-day crystallisation event and effectively reduce the amount of LTA available; this effectively means that they are only tested against the client’s lifetime allowance once the first crystallisation has made after 6th April 2006.
With this in mind it is now more important than ever to receive proper advice and planning, especially for those clients who have defined benefit schemes which started to be paid prior to 6th April 2006 as these usually increase each year in line with a fixed rate, meaning that the longer these clients delay crystallising further funds after 6th April 2006, the greater the reduction in available LTA will be due to these benefits.
Should funds be kept inside the pension or withdrawn?
The answer to this question depends on your objectives for the pension funds; where tax-efficient wealth transfer is the goal, inheritance tax (IHT) planning must also be taken into account as getting the IHT planning wrong will usually more than wipe out any tax savings from LTA planning.
If funds withdrawn from the pension are likely to attract IHT, within either the client’s or beneficiary’s estate, leaving them inside a modern flexible pension for loved ones to inherit as a drawdown pot will generally deliver a larger legacy. This is because a 40% IHT charge on top of any income tax the client pays to withdraw funds will almost always add up to more than the effective rate of tax that beneficiaries will pay to take funds from the pension wrapper as needed. In addition, anything left unused inside the pension remains sheltered from IHT for future generations.
Where immediate access to the funds is required, however, careful planning must be considered to ensure that any potential tax implications based on a client’s financial position are taken into account.
A pension is a long-term investment not normally accessible until 55. The value of your investment (and any income from them) can go down as well as up which would have an impact on the level of pension benefits available. The tax implications of the lifetime allowance and pension withdrawals will be based on your individual circumstances, tax legislation and regulation which are subject to change in the future.