UK pension drawdown – managing your exposure to the Lifetime Allowance Charge
The new pension freedoms on offer since 6 April 2015 have allowed individuals to become more strategic in the way they access their UK retirement funds. Traditionally, the tax-efficient way to drawdown your assets in retirement is to access taxable assets, tax deferred assets and tax exempt assets. These freedoms provide the ability to meet retirement needs in a way that can also mitigate your tax bill.
Some individuals have significant assets outside of their pensions to provide for some or all of their needs in retirement. When this is the case, there may be a number of benefits to maintaining your balance within the pension wrapper for as long as possible. Among others, growth can continue to compound inside a tax-deferred wrapper and UK pensions are held outside of an individual’s UK estate for Inheritance Tax (IHT) purposes.
However, an unintended consequence of seeking to maintain pension assets within its wrapper combined with the current lower lifetime allowance thresholds is that individuals may need to manage their pension balances in a way that limits their exposure to the lifetime allowance (LTA) charge. A pension gets tested against the LTA when a benefit crystallisation event (BCE) takes place. There are currently 13 different BCEs and each time benefits are drawn from a pension scheme the value of the benefits are measured as a percentage of the LTA for the relevant tax year. It is when a member has crystallised more than the LTA amount that there is a tax charge of up to 55% on the excess. It is often prudent to try to avoid this situation.
An example can help illustrate how one might deal with the scenario of bumping up against the LTA but wants to keep their pension largely intact and invested inside the pension wrapper:
Alexander is approaching his 55th birthday and his defined contribution pension balance is £1.24 million. He has secured Fixed Protection 2016 which provides LTA protection of £1.25 million. Upon his 55th birthday, Alexander can crystallise the entire balance of his pension by moving into flexible access drawdown. This move tests the pension against his LTA and allows Alexander to take his 25% tax-free lump sum, but also keeps the remaining assets invested inside the pension wrapper. Under this scenario, the pension won’t be tested again until age 75. If, before age 75, any growth experienced in pension between the first crystallisation event (in this example at age 55) to age 75 is distributed, then the balance left in the pension should not be exposed to an LTA charge. Post 75, the original £930,000 pension balance (pension value tested against the LTA less the pension commencement lump sum) can remain invested inside the pension wrapper until Alexander’s death without being exposed to any further LTA testing.
For individuals looking to do legacy planning, this can potentially be a powerful option to consider in the right circumstances. In the instance that the individual is also a US person, there can be a few additional complexities in the planning to consider before deciding on the appropriate strategy for yourself. It is almost always beneficial to take advice from a US-UK qualified professional who can help you understand how the rules impact you and help you develop a strategy that makes sense for your situation and broader objectives.
For more wealth planning tips and tidbits from MASECO read our 39 Steps to Smart Living in the UK.