How do Lifetime Allowance charges work?

koru

Can anyone tell me in more detail how the Lifetime Allowance (LTA) charges work for a SIPP (or point me to somewhere that explains it)? I can find lots of explanations of the limits, but not the mechanics of what happens if you exceed the LTA.

Let's assume you retire at 60 and start drawing income from your SIPP. (You can withdraw 25% tax free, but let's ignore this for a moment.) If the value of your pot is lower than the LTA, I believe you pay income tax at your marginal IT rate, which for most retired people is going to be no higher than 20% basic rate tax, unless the pension income that you take, plus any other income, exceeds the threshold for 40% tax, which is currently £45k (including the £11.5k personal allowance). If you exceed the LTA, I understand the tax rate is 25%. This is instead of, not on top of, your marginal income tax rate, right?

But is this just levied on a portion of the income? Is it proportional to the extent by which you exceed the LTA? So, if your pot is valued for these purposes at £1.5m, your 'excess' pot is (1.5-1.0)/1.5=33% of your pot. (Let's assume the LTA is £1.0m, though I realise it might rise to track inflation.) So, I'm guessing 33% of each income draw is taxed at 25% and the rest at your marginal income tax rate. Is that right?

Or is the whole withdrawal taxed at 25%? Presumably this would apply until your cumulative withdrawals equal the excess, which is £0.5m in my example.

How does the 25% tax free lump sum impact on this? Is the calculation done on the basis of your pot net of the 25% tax free lump sum, assuming you decide to take it? So, in my example, if you have a pot of £1.5m, you can take 1.5/4=£375k tax free lump sum, leaving a net pot valued at £1.125m. Meaning you exceed the LTA by £125k, which is 0.125/1.125=11.1% of your net pot.

Is each further income draw a separate crystallisation event, so you recalculate the excess each time, based on market values? Or do you keep applying the same proportion as the first draw?

I understand there is an automatic crystallisation event at age 75, if you are still alive and have money left in your pension. So, you revalue your pot then. Does this only apply if you haven't already started taking anything from your pension, or does it apply regardless? Assuming the revalued pot at age 75 exceeds the LTA, is the excess all taxed at 55% and if so, do you pay this tax straightaway or only when you take money out of the pension? Or, if you continue just drawing regular income, can you carry on just paying tax at 25% on the excess proportion of income drawn?

How does all that work if your marginal IT rate is 40%? That's higher than 25%, so is the 25% LTA rate is irrelevant? It seems unlikely that the LTA does not hit higher rate tax payers, but if it does hit them, how is this done?

dmelife

The 25% rate is charged on any excess before income tax, not after. However, if you take the excess as a lump sum it is charged at 55% tax, but without an income tax liability.
The charge will apply once you crystallise funds above the LTA.

TcpnT

How does the 25% tax free lump sum impact on this? Is the calculation done on the basis of your pot net of the 25% tax free lump sum, assuming you decide to take it? So, in my example, if you have a pot of £1.5m, you can take 1.5/4=£375k tax free lump sum, leaving a net pot valued at £1.125m. Meaning you exceed the LTA by £125k, which is 0.125/1.125=11.1% of your net pot.

This is incorrect. The 25% TFLS is limited to 25% of the current LTA. So at the moment with LTA of £1m you can only take £250k as TFLS. If you have LTA protection at one of the earlier levels your max TFLS would be 25% of that number

EdSwippet

koru wrote: »

This is instead of, not on top of, your marginal income tax rate, right?

No. It comes off before your marginal income tax rate. See below.

koru wrote: »

But is this just levied on a portion of the income? Is it proportional to the extent by which you exceed the LTA? So, if your pot is valued for these purposes at £1.5m, ...

Assuming you do not hold any LTA protections, if you were to crystallise the entire £1.5m you would pay 25% of £500k so £125k in LTA penalty and could take £250k tax-free in PCLS. The remainder can then be used as taxable drawdown or for an annuity. You can crystallise less than the full pot if you wish, for example £1m would get you the PCLS and defer the LTA penalty. You 'use up' your LTA in percentages with each crystallisation, so crystallising £1m would use 100% and leaves you just outside LTA penalty charge territory. Any future crystallisation(s) would be all subject to LTA penalties.

Notice here how the LTA is a de facto limit on the tax-free PCLS. In effect, below the LTA you get the 25% tax-free; above it, the government takes it instead of you getting it.

The LTA rises to £1.03m in April. It is set to rise with inflation each year in future, but you should expect your pension pot to grow faster than inflation, so this LTA inflation linkage does not solve a great deal of the LTA problem.

koru wrote: »

How does all that work if your marginal IT rate is 40%? That's higher than 25%, so is the 25% LTA rate is irrelevant? It seems unlikely that the LTA does not hit higher rate tax payers, but if it does hit them, how is this done?

You pay the 25% LTA excess penalty, and then marginal income tax on the remaining 25%. So a basic rate taxpayer pays 25% + 20% of 75% = 40% tax, and a higher rate taxpayer 25% + 40% of 75% = 55% tax.

Additional rate tax would result in 25% + 45% of 75% = 58.75% tax, and the effective 60% allowance phaseout band would result in 25% + 60% of 75% = 70% tax. For these two cases, taking a full lump sum and paying the 55% lump sum rate would be the better option.

A web search for "benefit crystallisation events' returns a reasonable crop of papers that might help you sort out some more of the detail here.

koru

Thanks for all these answers. My assumptions were badly wrong!

So, thinking through some of the consequences:

1 Presumably anyone who is only receiving basic rate tax relief on current contributions really should try to make sure their contributions don't push them over the LTA, because they are getting relief at 20% and would effectively be paying 40% on the way out? This means trying to anticipate how much their current pot might grow between the time of the contribution and the time they crystallise, which is very tricky. So depending on how long until you expect to crystallise, to play it safe you might decide to stop making contributions when your pot is 'just', say, £500k.

2 If you are getting relief on contributions at 40% and you are likely to be a basic rate taxpayer when retired (which is a bit easier to forecast), the LTA penalty charge isn't as bad, because it just claws back the relief.

3 You can defer paying any LTA penalty charge by making sure you don't crystallise amounts that cumulatively add up to more than the LTA. But this deferral expires at age 75 and anything you haven't crystallised is deemed to be crystallised. Broadly correct?

4 Am I right in thinking that deferral has a serious potential downside, because waiting may mean that the value of the uncrystallised amount may have risen, so you could end up paying the LTA penalty charge on a much bigger amount than if you crystallised earlier?

5 If I'm right on 4, presumably if you are, say, 60 and your pot is currently under the LTA, you would be better off crystallising the whole lot immediately, to ensure your pot does not grow enough that you exceed the LTA? Crystallising doesn't mean that you necessarily pay income tax, unless and until you actually draw the money.

6 I'm trying to follow the comment about the LTA being a de facto limit on the tax-free PCLS. I think you are just saying that the maximum tax-free lump sum is 25% of the LTA, so to the extent that you exceed the LTA there is a double whammy on the excess amount: in addition to the LTA penalty charge, you also get no tax-free allowance on any of your pot that exceeds the LTA. So, for a basic rate taxpayer who crystallises a pot of £1m (to make maths easy, assume LTA = £1m), they can take £250k tax free and pay IT at 20% on the rest, so an effective rate of 15% on the total £1m. Whereas if their crystallised pot is £100k higher, they still only get £250k tax free, and the excess £100k suffers £25k of LTA penalty charge, leaving a net £75k, all of which is subject to 20% IT when it is drawn, meaning an effective 40% tax rate on the excess. (Or, if more than £250k is taken as a lump sum, the effective rate is even worse, at 55%.) Is that right?

EdSwippet

koru wrote: »

1 Presumably anyone who is only receiving basic rate tax relief on current contributions really should try to make sure their contributions don't push them over the LTA, because they are getting relief at 20% and would effectively be paying 40% on the way out? This means trying to anticipate how much their current pot might grow between the time of the contribution and the time they crystallise, which is very tricky. So depending on how long until you expect to crystallise, to play it safe you might decide to stop making contributions when your pot is 'just', say, £500k.

Broadly speaking, yes. With a real return of 5% a person aged just 40 might expect this £500k pot to breach the LTA at age 55. Or if aged 50, by age 65.

There are occasions where stopping contributions can be more harm than good, though. If you would lose a valuable employer match with no compensatory uplift in normal salary, for example. In that case it is probably better to continue regardless (depending on the level of employer match).

koru wrote: »

2 If you are getting relief on contributions at 40% and you are likely to be a basic rate taxpayer when retired (which is a bit easier to forecast), the LTA penalty charge isn't as bad, because it just claws back the relief.

That's how the maths works out, and it is probably deliberate policy on the part of the government.

Do note however that you will also pay 40% on the investment growth that occurs within the pension, whereas if you could invest the same money outside of a pension your normal income tax and any capital gains tax would almost certainly be lower than this 40% pension withdrawal rate.

koru wrote: »

3 You can defer paying any LTA penalty charge by making sure you don't crystallise amounts that cumulatively add up to more than the LTA. But this deferral expires at age 75 and anything you haven't crystallised is deemed to be crystallised. Broadly correct?

Yes. The age 75 test is spiteful, but nevertheless it exists.

Remember that it also applies to growth in already crystallised but not yet drawn down elements. You could crystallise a £1mm pension tomorrow, take the PCLS and leave the rest untouched and yet still face an LTA charge at age 75 on the untouched part. The simple solution to this is to draw down enough at normal income tax rates before age 75 to ensure you duck under the second LTA test at age 75. Again, normal income tax is probably lower than the 55% LTA penalty rate.

koru wrote: »

4 Am I right in thinking that deferral has a serious potential downside, because waiting may mean that the value of the uncrystallised amount may have risen, so you could end up paying the LTA penalty charge on a much bigger amount than if you crystallised earlier?

Once you exceed the LTA, yes, you would hope that your funds grow rather than shrink. And that growth sits in a region of higher tax than it did before you exceeded the LTA.

One possible strategy that has come up a couple of times here is to wait for a decent market crash before crystallising, jump the LTA hurdle at that point by crystallising, and then let the recovery happen in the now-crystallised funds. That may be an option for folk past the LTA but under age 55, for whom crystallisation is not an option. Personally I think it a bit risky -- the crash might not happen when you need it, it might not be deep enough, you might not be able to judge it correctly, and so on -- but there are some smart folk around here who think it might be a viable way forwards for some, so who am I to argue?

koru wrote: »

5 If I'm right on 4, presumably if you are, say, 60 and your pot is currently under the LTA, you would be better off crystallising the whole lot immediately, to ensure your pot does not grow enough that you exceed the LTA? Crystallising doesn't mean that you necessarily pay income tax, unless and until you actually draw the money.

The optimum time to crystallise if you are over age 55 is the point where your pension pot exactly reaches the LTA. Below the LTA you would be forgoing a bit of potential PCLS (although you might later on want to use your remaining LTA percentage at the age 75 BCE). And above the LTA you are losing out to the higher tax rate of the LTA penalty.

This assumes you do not plan to use your pension as an inheritance tax bypass rather than as a pension.

koru wrote: »

6 I'm trying to follow the comment about the LTA being a de facto limit on the tax-free PCLS. ...

Suppose your pension is £2mm and the LTA is £1mm, for easy numbers. Your first £1mm crystallised nets you £250k tax-free and £750k taxable as income. Your second £1mm crystallised nets the government £250k in LTA penalty tax, and you another £750k taxable as income. So up to the LTA you get the PCLS, but after it the government takes that away from you entirely.

Before April 2016 the LTA was £1.25mm. Here your second £1mm crystallised would have netted a you further £63k tax-free before the LTA penalty kicked in, for a total across both crystallisations of a £313k tax-free element.

You can never realise more than 25% of the LTA in PCLS. This means that each time the government reduces the LTA it also shrinks (by the same proportion) the maximum PCLS that it is possible to realise from a pension.

goRt

Yes, the LTA is a disincentive to save, the BCE7 at age 75 particularly so - you are encouraged to 'bleed' money out of your SIPP that you may not need just to avoid the 55% hit.
I'm not sure how that promotes saving.

koru

@EdSwippet
Your answers are amazingly helpful. Thank you for taking so much time to spell it out in such a thoughtful manner.

@goRt
I presume the government considers that those of us who are fortunate enough to have pension savings of £1m (or the prospect of this in the future), which can produce a sustainable real return of perhaps £30-40k, will manage just fine. So, promoting more saving than that is not their priority. (Especially as many such people will also have big ISA pots too.)

I don't like paying tax, but I do agree this is probably necessary. I just wish there was a different mechanism than the LTA, because it means massive uncertainty about the point at which basic rate taxpayers should stop making contributions. A 55 year old with a pot of £500k should probably stop, because there's quite a good chance of that growing to more than the LTA before they can get it out of the pension without paying higher rate tax. But then stock markets are at pretty high levels measured by CAPE and so on, so there's a fair chance that markets will crash and in 10 years the market might have shown no net growth, so that person might retire with a pot of 'only' £500k, and they have foregone a lot of tax relief they could in fact have used. It would be a lot easier if they just capped lifetime contributions. Perhaps this is deliberate, as it means many people will use less relief than they could have claimed and/or that many people who assume they are never going to fall foul of the LTA end up doing just that.

Triumph13

A couple of little points to add.
Whilst crystallising as soon as possible to avoid the issue of funds growing faster than the LTA clearly makes sense, that only applies up to the amount of the LTA. With a £1.5M fund it makes no difference whether you crystallise the £1M now and the remaining £0.5M later or do it all at once. If over the next 10 years your investments went up 60% then options would be crystallise immediately => 0.75 x 500 x 1.6 or crystallise at end => 500 x 1.6 x 0.75
The LTA test at age 75 is vicious for people over LTA because it compares the value of drawdown funds still in your pension with their value at the point of crystallisation without any allowance for inflation. You need to make sure you withdraw ALL the investment growth, not just the 'real' return.