Lifetime Allowance Tax explained ?

Albermarle

If you are approaching LTA , it makes sense to me to switch into lower risk/lower return funds. Better to do this then stopping contributions, and losing out on free money from employer/HMRC
With higher return funds you are taking the risk of breaching the LTA and on the other side a big drop in funds if markets crash. In other words you are taking risks for no clear reason.

caveman8006

Totally agree with Albermarle - for those approaching the LTA cap, particularly if they intend to retain as much as possible in their IHT exempt pension pot to bequeath, then it makes complete sense to use the pension pot for low-risk/low return bond/cash instruments and keep their equity-risk assets in uncapped ISAs. At the LTA cap, all returns have to be taken as taxable income (or they will be subject to the LTA penalty tax) so having assets with "risky" expected returns of 6%+ ensures you will pay higher rate tax whereas if you stick with cash/bonds returning a "safe" 2-3% you can be certain that you will only be subject to basic rate tax on state/private pension income.


Put another way, assuming you have a £1m DC pension pot and a £1m ISA pot, then it is much more tax efficient to use the ISA for equities (returning, say, 6% or £60k pa tax free) and the pension for cash/bonds (returning, say 2.5% or £25k pa leaving plenty of room for a full state pension on top subject to only basic rate tax). Structure it the other way round, and you would be typically be generating £60k +£8k (state pension) - £50k (higher rate allowance) = £18k+ of income subject to higher rate tax unnecessarily.

cfw1994

Albermarle wrote: »

If you are approaching LTA , it makes sense to me to switch into lower risk/lower return funds. Better to do this then stopping contributions, and losing out on free money from employer/HMRC
With higher return funds you are taking the risk of breaching the LTA and on the other side a big drop in funds if markets crash. In other words you are taking risks for no clear reason.

That is an interesting viewpoint....and perhaps sides with the “default glidepath” our Aviva plan has: as you approach your chosen retirement date, it starts to move increasing sums into bonds, gilts & cash, so by the point of retiring, it is almost 100% in those.

I understand the approach....but to be frank, if I had done that, 15 years ago when I started taking an interest and tweaking the funds, I would be nowhere near to hitting the LTA :think:

Perhaps that says more about my approach to risk....but I actively chose to “tinker” with that in order to get greater returns: I do understand the greater risk from market exposure once drawing down (when unable to add beyond the £4K MPAA), but it is one (to a degree) I am willing to take.
On that point: if one followed Triumph’s “crystallise the whole lot up front, paying your LTA charge and getting it out of the way”....but do NOT actively take money from the chunk in drawdown, does that trigger the MPAA? I suspect not, reading this.

I should perhaps add we do have some other sources of funds to use in leaner years.

I personally feel that there is an element of over caution in moving down this path just because of the risk of hitting the LTA :think:
The fund will be funding (I hope!!) 25-40 years of retirement ahead. I still want it to grow (risks understood!). This is more (to me) about identifying the most tax effective way to withdraw if I do hit the LTA.

caveman8006 wrote: »

Totally agree with Albermarle - for those approaching the LTA cap, particularly if they intend to retain as much as possible in their IHT exempt pension pot to bequeath, then it makes complete sense to use the pension pot for low-risk/low return bond/cash instruments and keep their equity-risk assets in uncapped ISAs. At the LTA cap, all returns have to be taken as taxable income (or they will be subject to the LTA penalty tax) so having assets with "risky" expected returns of 6%+ ensures you will pay higher rate tax whereas if you stick with cash/bonds returning a "safe" 2-3% you can be certain that you will only be subject to basic rate tax on state/private pension income.

Put another way, assuming you have a £1m DC pension pot and a £1m ISA pot, then it is much more tax efficient to use the ISA for equities (returning, say, 6% or £60k pa tax free) and the pension for cash/bonds (returning, say 2.5% or £25k pa leaving plenty of room for a full state pension on top subject to only basic rate tax). Structure it the other way round, and you would be typically be generating £60k +£8k (state pension) - £50k (higher rate allowance) = £18k+ of income subject to higher rate tax unnecessarily.

Also understood....but I am not going to get anywhere close to such a huge ISA pot (perhaps because I fed the pension fund first!)

Someone once told me “the more tax you pay, the more you have earned: that is good!”.
Yes, we all want to minimise tax, hence my questions here, but the pension funds are massively tax efficient on the way in: paying a bit more on the way out is undesirable, but I’ve not seen the maths yet that shows me I’d have been better paying 40% on it in order to invest in ISAs versus paying more on the withdrawals due to going over the LTA.

Hence my finding Triumph13’s approach interesting (“You will probably be better of crystallising the whole lot up front, paying your LTA charge and getting it out of the way“).

I clearly need to do the sums...perhaps now is the time to engage a clear, concise IFA to help us, if I can find such a person! I may also call the Pensionwise folk first to get their take on it: anyone got views on how useful they can be?

Sorry for such a long reply....& thanks for the input, and any more thoughts are welcomed!

EdSwippet

cfw1994 wrote: »

I understand the approach....but to be frank, if I had done that, 15 years ago when I started taking an interest and tweaking the funds, I would be nowhere near to hitting the LTA.

That's why Albermarle only suggested that you do this if you are approaching LTA. That is, if your projections indicate that you will exceed it.

Think of it this way.

• Below the LTA, pensions are tax efficient. In part because of the tax deferral on both contributions and growth, but mostly because of the 25% tax-free lump sum, with marginal income tax only on the remainder. This is better than investments outside of a pension.
• Above the LTA, pensions are a tax ball-and-chain. You lose the 25% tax-free lump sum, and have to pay the government 25% in 'lifetime allowance tax charge', applied to both contributions and growth, and then your marginal income tax rate on what remains. This is worse than investments outside of a pension.

These tax rules motivate reaching the LTA, but also strongly motivate not exceeding it. There are however some cases in which exceeding the LTA beat stopping on reaching it, particularly where exceeding it is either unavoidable or has already occurred. Losing a sizeable employer contribution match, for example. This mostly tends to affect people in DB pensions rather than DC ones, where there can sometimes be more flexibility.

cfw1994 wrote: »

I’ve not seen the maths yet that shows me I’d have been better paying 40% on it in order to invest in ISAs versus paying more on the withdrawals due to going over the LTA.

Assume a higher rate taxpayer. Take £100 of salary leaves you £58 after tax and NI. Or, pay £100 gross into a pension below the LTA, withdraw with £25 tax-free and £75 taxed at 40% leaves you £70, more than £58. Or, pay £100 gross into a pension above the LTA, withdraw with £25 LTA tax penalty and £75 taxed at 40% leaves you £45, less than £58.

Numbers vary if your tax rate is not constant. The example usually given is where you drop from higher rate tax to basic rate of 20% in retirement. In that case you get £60 back from a £100 gross into a pension above the LTA, so virtually the same as if you had just taken the income, but where your money is tied up for perhaps decades rather than being immediately available.

However, anyone with a pension at the LTA may find it hard to remain in basic rate tax in retirement, because the rules also strongly motivate taking all the nominal gain -- that is, real plus inflationary gain -- in the crystallised pension as taxable income in the years before age 75, when there is a second spiteful LTA test and possible penalty.

shinytop

Well this thread has been an eye-opener for me. Like the OP I had completely the wrong idea. I had a vague notion that I could contribute up to the LTA but as long as the amount I had in my combined pensions at any one time was under, I didn't have to worry. And that something else happened at 75 but I wasn't really sure what. I now see I'll have to put some thought into this. My DB pension at 20x plus my DC will be slightly under LTA but the way I now understand it growth is likely to put it over. As had been said, I think the best approach for me is to achieve the most growth I can outside the pension wrapper. That will mean taking the maximum TFLS at the start and drawing down as much as I can each year without paying HRT. Yes, it's a nice problem to have but no point in paying more tax than I need to.

EdSwippet

shinytop wrote: »

Well this thread has been an eye-opener for me. Like the OP I had completely the wrong idea. ...

You'll have plenty of company on this, so don't beat yourself up. The whole area has been so complexificated by muddle-headed politicking that it is now very hard indeed to find a clear way through the thicket of restrictions, regulations, protection regimes, and so on.

At one end of things, a lot of people are sleepwalking into oversized tax bills because they are entirely unaware that they will breach the LTA, due to the non-intuitive way it operates. And at the other end, some people are so acutely nervous of the LTA that they are cutting back on pension saving and so forgoing a decent chunk of tax deferral that they might otherwise use. In both cases the investor loses, and the government wins by collecting more tax, either in the future or now. A more cynical person than I am might suggest that this is by design ...

cfw1994

EdSwippet wrote: »

<good stuff>

Assume a higher rate taxpayer. Take £100 of salary leaves you £58 after tax and NI. Or, pay £100 gross into a pension below the LTA, withdraw with £25 tax-free and £75 taxed at 40% leaves you £70, more than £58. Or, pay £100 gross into a pension above the LTA, withdraw with £25 LTA tax penalty and £75 taxed at 40% leaves you £45, less than £58.

Numbers vary if your tax rate is not constant. The example usually given is where you drop from higher rate tax to basic rate of 20% in retirement. In that case you get £60 back from a £100 gross into a pension above the LTA, so virtually the same as if you had just taken the income, but where your money is tied up for perhaps decades rather than being immediately available.

However, anyone with a pension at the LTA may find it hard to remain in basic rate tax in retirement, because the rules also strongly motivate taking all the nominal gain -- that is, real plus inflationary gain -- in the crystallised pension as taxable income in the years before age 75, when there is a second spiteful LTA test and possible penalty.

That is the maths I should have taken time to figure out: thank you!
(& to the ones above too who tried to explain to my thick skull!)

Does rather make me think I need to curb back my pension input, perhaps significantly.....hmmmm!
Back to the spreadsheet ;-)

MarkCarnage

First time poster here, and have been considering some of the issues explored above myself.

I have a combination of decent DB scheme which I have just started taking benefits from along with 25% tax free lump sum (half funded by AVCs), and a SIPP, which includes the CETVs of two smaller DB schemes where I took advantage of pretty reasonable TVs a year or two ago.

Despite having elected for FP at £1.25m level, I would hit that limit now if I crystallised my SIPP.. There are so many perverse 'incentives' and distortions around this politically contrived LTA and taper system that it's hard to know where to start....how about the perverse penalties which apply to good investment performance for one?

It strikes me that it might be good to wait for a significant market setback, then move one's fund to drawdown (taking 25% tax free cash) thereby crystallising it at lower levels for LTA purposes. Then manage it with an eye to avoiding the second LTA trap at 75, by taking income accordingly.

Picking up on another point above, I think that the chances of getting 10% annualised nominal returns/ 7% real returns on a sustained basis from here are close to zero. I am working on equity returns of maybe 6% before charges, bonds might be half that.

Another interesting arbitrage for those who have a DB pension is that taking it early (if it works for you financially) can actually help with LTA, as the multiplication factor remains at 20, which is a tad illogical as you will be getting the lower amount of pension for longer in theory and hence the NPV of the total amount paid to you should be the same regardless of when you retire (assuming life expectancy is the same clearly).

One wonders how many others will gradually be sucked towards the LTA trap over the years without realising it.....

EdSwippet

MarkCarnage wrote: »

First time poster here, ...

Welcome aboard!

MarkCarnage wrote: »

Despite having elected for FP at £1.25m level, I would hit that limit now if I crystallised my SIPP.

Hit, or exceed? You don't say how old you are, but from preceding statements it looks like you are over age 55. In that case, crystallising the pension up to but not necessarily beyond the LTA now, even if you don't immediately need the money, should at least reduce the future LTA penalty pain, because it will mean that a lot less of your money will be growing into the LTA penalty zone. Worth working through the numbers, anyway.

MarkCarnage wrote: »

There are so many perverse 'incentives' and distortions around this politically contrived LTA and taper system that it's hard to know where to start....how about the perverse penalties which apply to good investment performance for one?

Indeed. If you started out with a blank sheet of paper and a goal of constructing a retirement savings framework that is as complex, arcane, baroque and un-navigable as you could, what we have now could well be the sort of thing you would come up with.

MarkCarnage wrote: »

It strikes me that it might be good to wait for a significant market setback, then move one's fund to drawdown (taking 25% tax free cash) thereby crystallising it at lower levels for LTA purposes. Then manage it with an eye to avoiding the second LTA trap at 75, by taking income accordingly.

This idea has come up a number of times on this forum in the past. If you do a search you can probably find the appropriate threads.

Smarter people than me have advocated it, and maybe they're right. The problems I have with it personally, though, are

• unless it gets you fully under the LTA you have to call the bottom, and that's going to be impossible for all practical purposes;
• a diversified portfolio contains both stock and bonds, and will not drop anything like 30% if stocks drop 30%;
• and there is no guarantee that a market dip will come when you need it, or be as deep as you need.

Case in point -- markets have risen inexorably probably 30% or more since I first saw it suggested, so anyone then who was waiting for a small-ish dip is now waiting for a massive one that may well not materialise. You might get lucky with this idea then, but luck is not a strategy.

MarkCarnage wrote: »

One wonders how many others will gradually be sucked towards the LTA trap over the years without realising it.....

The folk at Royal London recently suggested around 1.25 million: LTA timebomb to hit more than a million workers

Thrugelmir

cfw1994 wrote: »

I understand the approach....but to be frank, if I had done that, 15 years ago when I started taking an interest and tweaking the funds, I would be nowhere near to hitting the LTA :think:

Perhaps that says more about my approach to risk....but I actively chose to “tinker” with that in order to get greater returns:

No one foresaw the extent of Central Bank intervention in the markets. Difficult not to have made money in the past few years. Challenge is that with gilts and investment grade corporate bonds only offering around 2%. The next 15 years is unlikely to be anywhere as near as rewarding. Taking risk (e.g. high equity allocation) may be the only available option if the objective requires a high level of return.