One of the important things to remember with drawdown is that your pension fund may be tested more than once against the lifetime allowance (LTA); once when you go into drawdown and again when you reach age 75. As you can currently first access drawdown at age 55, there are up to 20 years in which to forget about the latter test.
Changes to the tax treatment of pensions on death introduced in 2015 with the pensions freedoms mean more people are choosing to remain in drawdown. That means more people will need to understand how the test at age 75 works and whether they should take any action in anticipation of it. The best thing you can do is to speak to your financial adviser about it. Here, we first decipher some jargon and then take you through a case study to bring the issues alive.
What is the lifetime allowance?
The lifetime allowance (LTA) is a limit on an individual’s tax-privileged pension savings. The standard LTA is £1.055m for 2019/20, although some individuals have registered for a higher LTA by means of Protection. An individual’s pension funds are not continuously tested against the LTA; rather the test is only carried out at certain events (most commonly when drawing benefits and/or on death). Members are allowed to breach the LTA at these events, although excess tax charges usually apply in such cases. The LTA tax charge is 55% where the excess is paid as a lump sum to the member, or 25% where the excess is retained within the scheme to provide the member with a taxable income.
LTA test on drawn (“crystallised”) funds at age 75
Investment growth on any drawdown funds established after 5 April 2006 will be tested against the LTA at age 75. This event, (officially called “Benefit Crystallisation Event (BCE) 5A”), is particularly significant: it is often the last time your pension savings will be tested and may incur a sizeable tax charge at a fixed date – namely, your 75th birthday - unlike drawing benefits, which can be strategically phased. Funds in excess of the available LTA at age 75 cannot be paid to the member as an LTA excess lump sum (subject to 55% tax); they must be retained within the scheme, thereby incurring a 25% LTA charge.
The following Case Study shows how this ‘age 75 test’ works in practice.
Charlotte drew benefits from her SIPP at the age of 69 in February 2019, at which point her fund value was £900,000. She drew a tax-free lump sum of 25% of her fund (i.e. £225,000) and used the remaining £675,000 to provide a Flexi-Access Drawdown pension. Since the LTA was £1.03 million in February 2019, she used 87.37% of her available LTA in total.
Charlotte’s exposure to the LTA does not end there. Any investment growth on her initial drawdown fund of £675,000 will be tested on her 75th birthday. Her financial adviser points out that, should her SIPP investments perform well over the next six years, she is likely to be subject to an LTA tax charge on her 75th birthday.
Option 1 – do nothing
Charlotte’s financial adviser anticipates that if she does nothing, she will be subject to an LTA tax charge when she reaches age 75.
He anticipates her drawdown fund at age 75 to be valued in the region of £960,000, representing a growth of £285,000. Charlotte has remaining unused LTA of 12.63% so, assuming inflation of 2% for the entire interim, her LTA charge will be £34,450.
The remaining funds will continue to benefit from tax-free returns and are held outside of Charlotte’s estate for Inheritance Tax purposes.
However, this tax charge looks unappealing. In addition, any payment made from remaining funds will be subject to income tax (either in Charlotte’s hands or those of her beneficiaries where made following her death). Pension funds are also subject to the risk of unfavourable changes in legislation.
Option 2 – take income to reduce/mitigate the LTA charge
Charlotte’s financial adviser anticipates that drawing a gross annual pension of £20,000 from the SIPP will be sufficient to avoid the LTA charge altogether. Since Charlotte is a basic rate taxpayer, she will pay a total of £24,000 in income tax over the six-year period via PAYE, assuming the basic rate remains at 20% (note different rates apply in different parts of the UK). Her net pension receipts will be an asset of her estate and may, therefore, be subject to Inheritance Tax on her death.
On the other hand, she avoids having to pay the LTA charge of £34,450 and has the added assurance that the funds withdrawn now form part of her personal assets; they will not be affected by any government tinkering of pension legislation.
What about annuity purchase?
Charlotte’s circumstances may change in the future and her financial adviser may advise that she purchases a lifetime annuity before reaching age 75, other than seeking to avoid or minimise an LTA excess tax charge..
Prior to purchasing an annuity, Charlotte and her adviser would need to take her health and lifestyle into account, as well as the desired ‘shape’ of her annuity, and ensure that she ‘shops around’ for the best available annuity rate.
Indeed, individuals in drawdown should regularly review whether drawdown remains suitable. See our Briefing Note for more information.
Online registration for Fixed Protection 2016 and/or Individual Protection 2016 is still available. For instance, if Charlotte qualifies for Fixed Protection 2016, she can register using HMRC’s online registration process. This would fix her LTA at £1.25 million for any BCE’s occurring after 5 April 2016 (including the BCE 5A test on her 75th birthday unless the standard LTA increases to more than £1.25m, which would then become Charlotte’s LTA).
How long should I stay in drawdown?
In our briefing note we ask and answer some questions that you should consider when reviewing your choices. To find out more, download the document below.Find out more