The Lifetime Allowance: a tax trap for the unwary?

15th Sep '19 by Merlotman

38 comments 2150 reads

Not strictly an investing topic I know, but during a recent discussion thread a couple of us thought it would be helpful to find out to what extent others had considered the income tax implications of the new(ish) lower lifetime allowance limit (LA) limit. Please note that my post is based on a laymans rather than a qualified experts view and if you have any concerns you should seek professional financial advice.

Most will be aware that the LA applies to all DC and DB pensions and is designed so that a significantly higher income tax rate (55%) is applied to cumulative drawings in excess of the LA limit (currently £1.055m but rising in line with CPI). My understanding is that the limit is tested each time there is crystallisation event (normally a drawing under your pension) but also critically is automatically tested against the balance of monies in your schemes at age 75.

Using a simple spreadsheet I ran a number of scenarios one of which is as follows. A 55 year old has a pension pot of £600k (remember you have to add any DB scheme, multiplying the estimated annual income by 20 times, to the DC total). She/he continues to contribute 12% of their annual salary of £75pa until age 66. At age 67 they begin to drawdown 4% p.a. of their then pension pot. Assuming that their returns during the 20 years to age 75 average 2.5% above inflation or less they will not have a significant LA related tax charge. However that average return only needs to go up to 3% above inflation for a £100k tax bill to be payable at age 75. Based on many threads the average Stocko subscriber is achieving well above inflation plus 2.5% returns. The thing that surprises me is that the potential size of your tax bill is very sensitive to even small changes in the investment return. At the same time the test at 75 affects the usefulness of a SIPP as a mechanism for sheltering an estate against IHT.

Of course I may be misconstruing the way in which the LA is applied and would be interested to find out what conclusions others had reached and what strategies they were employing.

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jonesj

18th Sep '19

I would argue the main problem is the LTA itself.

Excessive taxation is a disincentive to work and this particular rule is possibly one of the worst examples of excessive taxation, since people suddenly hit a punitive tax rate.
In addition to the extraordinarily highly paid NHS staff retiring early, I expect there are also some talented people in the private sector retiring as well. Not good for the economy.

Unfortunately the house of commons seems to be stuffed full of thick politicians who cannot think through the unintended consequences of their policies.

Effortless Cool

Hopefully someone can help me understand the mechanics of how this tax works.

Scenario 1

I start drawdown from my SIPP and hit the LTA before the age of 75. My understanding is that I would pay tax on drawdowns at my marginal rate of income tax until I had reached the LTA and that any subsequent drawdowns would be subject to tax at 55% instead of my marginal rate. Is that correct?

Scenario 2

I leave my SIPP intact and reach my 75th birthday. This is the situation I am really unclear about. Is any excess in the SIPP over my LTA immediately taxable at 55%? If so, can I pay that tax out of the excess funds in the SIPP and is the balance of the excess then "liberated" from the SIPP and free of further tax? If this is not right, how does it work?

Additional question

If the amount in the SIPP exceeds the LTA, then is the maximum tax free cash available equal to 25% of the LTA?

Mike Rawson

Yes, it's the second option - damage limitation without bumping up the income tax bill.

It's definitely the case that lots of people quit when they reach the limit. I know several.

Once you can't make pension contributions, earning six figures is not so attractive.

Scenario 1 - no. In drawdown, the assessment is at the time you move the money into drawdown. You could then withdraw as much as you like under normal income tax rates until you hit age 75, at which point what's left will be assed again.

If you have multiple pots they can each be moved separately into drawdown. If you wait for a dip in the markets this is a good way to protect a large pot.

Scenario 2 - I'm not 75 yet but I think that the tax could be immediately liable. I want to avoid this situation of a large pot aged 75 in case the only way to pay it is a big withdrawal with extra income tax on top of the LTA penalty.

Additional question - the standard rule is that at each crystallisation event, the maximum tax-free cash 25% of the available LTA, which will have been reduced by all previous crystallisation events. So yes, the max TFC is 25% of £1.055M (unless you have taken protection at a higher pot size).

Thanks, Mike, although your answers have redirected, rather than resolved my confusion.

Let's take the example of my friend, who is 55 now, on a 50% marginal tax rate, and has £1.75m in a single SIPP with a £1.25m protected LTA.

If he takes his £312.5k maximum tax free cash then, as I understand your answer, he would be liable for £275k tax on the £500k in the SIPP in excess of the LTA.

My questions are:

- Can the tax be paid out of the £500k excess held in the SIPP, or does it have to be paid out of non-SIPP funds?

- Is the balance of the excess over the LTA (£225k) now available tax free? Or is it taxed twice: once at 55% on the crystallisation event and once at the relevant marginal rate when it is drawn down?

- Is there any advantage in trying to get funds out as early as possible, given the marginal income tax rate is almost as high as the penal LTA excess tax rate?

Grateful for any input (or my friend is, anyway).

He needn't be liable until age 75. If he moved £1.25M into drawdown, the £0.9375 remaining after the TFC could be taken as required, subject to income tax.

The excess over the LTA (£500K) would attract either income tax plus the 25% penalty or a 55% penalty if taken as a lump sum. The max TFC with £1.25M protection is £312.5K.

Your number of £225K is presumably after the lump-sum tax, so no further tax would be due. If taken as a lump sum, the tax is effectively being paid from the money in the SIPP.

The reason for getting funds out early is to use your allowances (0% and 20%) each year. If you are still earning more than £50K pa there's not as much point. Where is there a marginal rate of 50%? Scotland?

I stopped working 8 years ago - before I could withdraw. I have no other income so as a minimum I need to take £50K (I actually take £67K using UFPLS). My question would be why is your friend still working?

Thanks, Mike. I'll go and do some research based on your post before asking any more questions.

Picking up on your questions:
- the marginal rate of 50% exists only in my head; it should have been 45%; and
- he's still working because he's not yet ready to move to a post-retirement lifestyle, his wife even less so.

justinian

Of course, the other thing we don't know is what the income tax rate will be at the point one reaches 75. It is entirely possible that it keeps on inching up to the point that it is potentially broadly the same as the LTA 'penalty tax rate' or even more.

When I think about my daughter and her £50,000 Student Loan being repaid with an exhorbitant interest rate of 3% over RPI. Her deductions when she reaches being a higher rate tax payer, are eye watering. 45% income tax, then NI, then pensions (no longer non contributory) and on top of all that ,the Student Loan (which effectively acts as a tax) and London rents because the jobs do not really exist in great numbers elsewhere and most of her generation cannot afford the pumped up house prices.

We have little to complain about even faced with a 55% LTA deduction compared to all that their generation has suffered as the ladder has been pulled up in front of them. In fact, I wouldn't be surprised if the LTA tax level doesn't go up, that the State Pension is taxed and maybe a Wealth Tax to top it all. Oh and of course contributions no longer benefit from being tax free.

If you think it cannot happen, this is what one political adviser suggests:

https://www.politicshome.com/news/uk/economy/taxation/news/100824/tax-wealthy-pensioners-and-homeowners-pay-ballooning-public

But I wouldn't necessarily consider this to be particularly a Party political issue. The tax take has already massively gone up in the wake of the financial crisis and really it is just a reflection of the reality of an ageing population and that the taxes on the bubble profits from free wheeling banks under New Labour, disappeared in the wake of the financial crisis.

Merlotman

Gromley I am not a tax expert but that is my interpretation of the relevant HMRC paper which says "A higher tax charge is imposed on any benefits crystallising as a lump sum once the lifetime allowance has been exhausted (55 per cent, compared to 25 per cent where the chargeable amount is being retained in the scheme). See https://www.gov.uk/hmrc-internal-manuals/pensions-tax-manual/ptm084000

The Resolution Foundation has quite the track record in asking for more taxes but that doesn't mean they would be effective. Nor is supposed intergenerational unfairness particularly relevant to a discussion about how the LTA operates.

And if things are only going to get worse in the future, all the more reason to get yout money out as quickly as possible.

TimeAndTide

19th Sep '19

Do I understand correctly that the tax can be taken out of the pension pot. You don't have to suddenly pay it out of non-pension money? (I've read a lot of press articles on this but they never seem to be clear on this point!)

If so, then the pension is still very useful despite future tax because you can continue to compound without paying CGT and income tax as you go. This is why ISAs are great. If you are compounding normal non-pension, non-ISA money you'll end up with lots of income tax on dividends and CGT on gains which will reduce your rate of compounding with a large cumulative effect. This is especially true if you are buying and selling assets rather than just sticking money in an accumulating fund which you never sell.

So I don't understand why anyone would not want to keep charging on as fast as they can with their pension, especially anyone making good returns who'll pay a lot of CGT otherwise. No CGT or income tax until you are 75 is worth an awful lot...

On the other hand, if you can't pay the tax out of the pension pot and have to pay it out and someone retires with a £10m pension pot and little other money they would be bankrupted by the tax bill...

Zipmanpeter

"But I wouldn't necessarily consider this to be particularly a Party political issue"

Is the real (and I agree NOT Party specific) issue here the lack of honest and open debate about levels of tax required vs public services desired and who is entitled to this necessary.

For example, truthfully 'Investment' in the NHS is not an investment - it provides no additional returns, except perhaps if enables longer working lives or reduces the cost of care, neither of which are much talked about as benefits !! Caring for the sick /elderly is mostly a form of consumption (albeit one a civilised society should support).

Also again, without judgement, this audience is sensibly seeking to minimise its tax obligations and performing cost/benefit analysis on projects like temporary emigration before return to the UK (presumably for the NHS care in declining years since the sun will remain nicer in Portugal for example).

Unfortunately, democracy struggles here as everyone votes for more spending, special interests lobby for allowances and everyone seeks to minimise their own contribution. It is also tough for anyone to call out services once established to be withdrawn or not to be given once they have (re-)entered the community.

pka

Hi Financi_Al, you wrote:

"Do I understand correctly that the tax can be taken out of the pension pot. You don't have to suddenly pay it out of non-pension money? (I've read a lot of press articles on this but they never seem to be clear on this point!)"

The following article suggests that your understanding is correct:

https://www.boringmoney.co.uk/ask/exceeding-the-lifetime-allowance/

Gromley

Entirely worthless I am sure, but a bit of a philosophical spin on this.

I suspect that those that are going to be not very far over the LTA feel a bit aggrieved at being caught up with a draconian "fat cat tax" 55%!!

At a "safe" takeout rate of say 3% pa the LTA represents an annual income of £31.65k in today's money - hardly fat cat territory.

However, it is certainly a decent liveable amount for some one in retirement (with a lot of expenses like kids and mortgages a thing of the past).

The stated aim of the LTA arrangements are effectively to recoup the benefits that have been given when paying into the pension fund. In fairness these benefits are quite generous.

If when paying into the pension you were on a marginal tax rate of 40% and a margin NI rate of 12% then in effect each £100 paid in to the pension actually only cost you £48 in net terms. So the (upto) 55% tax rate on taking it out means that you get £45 back - so that is indeed fairly close.

In fact if as a pensioner you are in the 20% tax band (which at £31.65 you would be) then the marginal total tax rate on the excess is actually only 40% for any withdrawals as income. So for your (net) contribution of £48 you get £60 back.

When you consider this in the round, it does not actually sound unreasonable to me at all.

The purpose of the tax incentives on pension savings is to encourage people who can to make adequate provision to support themselves in retirement. Which £31k + state pension does adequately. They were not supposed to be a license for the 'rich' to become richer.

Of course there will be some amongst us who are facing up to LTA because of their skill at generating investment returns and who only ever paid tax at 20% (Tax + NI @ 32%). So they paid in £68 for every £100 entering their pension and only get back £45 per £100 (or £60 per £100 at the lower tax rate).

So perhaps this group have a reason to feel aggrieved?

I do not really think so. If you consider investing as a form of employment, I think the tax treatment we receive is actually pretty generous - those excess returns achieved within the pension scheme attracted no tax whatsoever at the time the were 'earned' so the additional tax you are going to incur when withdrawing them (or at least the portion above the threshold) doesn't seem unreasonable to me.

So of course I'm just going to bite the bullet and pay the "above LTA tax" right?

Not a bit of it. Of course I am going to use all of the smarts I have to try to reduce or avoid the tax exposure as I am sure will pretty much everyone else on this thread.

But lets not dress it up too much - we are talking tax avoidance which of course is totally legitimate and defensible, not to say totally sensible.

On reflection I am now quite sympathetic to the aims of the lower LTA, but if it were enacted more logically it would not be necessary (or possible) to jump through so many hoops.

20th Sep '19

The argument that pension tax treatment is generous is fine until we consider that our taxes are used to fund some generous final salary public sector schemes. The most generous of all seems to be that awarded to the MPs.

I don't think the hard working middle class should be expected to pay tax at a marginal rate of 40% to fund generous public sector pension schemes, without being granted tax relief to firstly provide for their own modest pension.

A more rational approach would be to scrap the LTA and cap the annual tax relief. Say at £40k a year & start reducing the annual allowance once the pot gets to a certain size.
A penal 55% tax rate is only ever going to encourage all sorts of avoidance methods, such as stopping working, emigrating and so on. You would think that the Conservatives and even the Liberals would be familiar with the concept of the Laffer curve.

timarr

You would think that the Conservatives and even the Liberals would be familiar with the concept of the Laffer curve.

Familiarity is one thing, giving it any credence is another. Arthur Laffer invented it as a purely theoretical demonstration that the previous economic truism that raising taxes automatically raised total taxation wasn't necessarily true. It became mainstream when Dick Cheney and Donald Rumsfeld seized on it as a way of legitimising "trickle down" economic theories in order to justify Reagan era tax cuts. As Laffer himself said, the real-world is far too complex to model using something as simple as his eponymous curve.

In fact the issue over LTA demonstrates his point - governments need money and locked-in pensions appeared to be a sitting target. But as we've seen with successive governments of various hues their ability to think through the consequences of their actions is limited, not to say non-existent - which is why we now see vital, skilled and experienced doctors choosing to retire rather than get hit by lump sum payments under the LTA. Creating profession specific exemptions will only lead to ever more complex avoidance efforts.

But I think it's quite amusing that "stopping working" is now a tax avoidance measure. Perhaps people ought to consider Hotblack Desiato's example and try spending a year dead for tax reasons? :)

GrahamF

Gromley

Not sure if I understood you correctly. My understanding is that there is no NI relief on pension contributions unless you’re employer is operating a salary sacrifice arrangement. Pension tax relief is a relief on income tax not NI as far as I know. But perhaps I misunderstood your calcs.

On the wider issue of principles, I tend to agree with most of what you’re saying.

To me, pension income tax relief is an incentive from the government to save a sum for my retirement. If the LTA is not so great in some respects, surely a greater injustice is that the people who need the most help to save, i.e. those on the lower incomes only get 20% relief rather than the higher rate of relief that most of us on here probably enjoy. (Especially considering, as you point out, that as our incomes are lower in retirement, a far larger proportion of our income in retirement is likely to be taxed at 20%).

Personally, I’ve stopped contributing to pensions because I may hit the LTA in years to come otherwise. However, there’s nothing to stop me or any of us from accruing further savings outside pensions and ISAs. I just not getting a government incentive to do so. And frankly, I tend to think that the less fortunate than myself should benefit from further government assistance before I do, if there’s any spare to go round.

21st Sep '19

Thanks pka, clear explanations are thin on the ground.

22nd Sep '19

Thanks Graham,

You’re quite right I was doing the wrong calculation, there is no NI relief on normal pension contributions, so my figures should have been.

£60 net paid in (40% rate taxpayer) becomes £100 gross in the pension, but comes out as

£45 - If taken out as a lump sum or at as income 40% marginal income tax rate

£60 - if taken out as income at the 20% tax rate.

So there is in fact an element of these charges being “penal”. Only those solely taking out income and staying below the higher rate tax threshold are seeing their excess benefit “equalised” the rest are being “penalised”. Which ought therefore to be a clear signal not to put excess into your pension. It does though get more complicated where employer match employee pension contributions.

There is also a tenuous case to say that the £40 initial tax relief acts like an interest free loan and that if investment performance exceeds inflation then it may still be beneficial.

It’s a complex situation, as I think we already knew!!

Anyway I do also broadly agree with you latter thrust on providing more pension saving incentives at the lower end.

It might seem perverse to offer someone 40% tax relief when they are only paying at 20%. But “progressive tax policies” (whether you agree with them or not) are intended to act as some form of leveller and in fact it may well be the case that increasing the level of (self-saved) pension income amongst the less well off has wider benefits to “the public purse” and to the wider economy.

Anyway I have probably steered us too far off the original thrust of this thread. So to give something back, I found the Hargreaves Lansdown LTA guide quite useful, it can be found here. It is far from answering all of the questions one might have (and if seems to focus far to much on the exemptions that some people can get) but I found it more helpful than most of the other information I’ve been able to glean so far.

The Lifetime Allowance: a tax trap for the unwary?

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Merlotman

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