Lifetime Allowance: how is tax applied if you exceed?

Chickereeeee

I currently have a couple of DBs in payment, and am drawing down on one SIPP. I have another SIPP, from which I have not taken anything. Under current valuations, I am at 90% of my (Fixed Protection 2016), and am wondering if I should crystallise the last SIPP to avoid breaching LTA. I don't need the lump sum cash for living, and it would be fed into ISAs over time. My thinking is that if I crystallise now, I preserve 10% LTA allowance 'headroom' for any future growth. Hence, if LTA increases by CPI I get some benefit, but if I wait until I hit LTA before crystallising, I don't.

I may or may not draw an income from the SIPP when crystallised, depending on 'events'.

(Age now 65, have children and wife)

Any thoughts of how I should proceed?

Also, I am unclear on how tax is applied if I exceed LTA. It seems 55% or 25% tax is applied to the excess (that portion over the LTA) for lump sum and income respectively. But how is that applied? If, say I had a SIPP with £500K, and that would be £100K over the LTA on crystallisation. Would 20% of the 'tax free' Lump Sum be taxed at 55%, and all future income withdrawals be taxed a combination of 80% at marginal rate and 20% at marginal rate+25%? Or have I got that wrong?

GSP

Good question. And for those knowledgeable ones who respond, if known could they say why LTA exists in the first place? Thanks

Albermarle

if known could they say why LTA exists in the first place? Thanks

Pension tax relief is a good tax break, especially for higher earners. So the LTA is there to stop wealthy people just using their pension as a tax avoidance scheme . Same reason why the annual allowance is there as far as I understand. 

EdSwippet

Chickereeeee said:

Also, I am unclear on how tax is applied if I exceed LTA. It seems 55% or 25% tax is applied to the excess (that portion over the LTA) for lump sum and income respectively. But how is that applied? If, say I had a SIPP with £500K, and that would be £100K over the LTA on crystallisation. Would 20% of the 'tax free' Lump Sum be taxed at 55%, and all future income withdrawals be taxed a combination of 80% at marginal rate and 20% at marginal rate+25%? Or have I got that wrong?

Suppose you are below age 65, have £400k of unused LTA remaining, and crystallise £500k of DC pension. There is no PCLS above the LTA. You would receive £100k (25% of £400k) in PCLS, pay £25k (25% of the excess above £400k) in PCLS penalty, and the remaining £375k moves into drawdown. You then pay income tax at your marginal rate as and when you draw from that £375k.

Chickereeeee

EdSwippet said:

Suppose you are below age 65, have £400k of unused LTA remaining, and crystallise £500k of DC pension. There is no PCLS above the LTA. You would receive £100k (25% of £400k) in PCLS, pay £25k (25% of the excess above £400k) in PCLS penalty, and the remaining £375k moves into drawdown. You then pay income tax at your marginal rate as and when you draw from that £375k.

OK that makes sense (I forgot about no PCLS above LTA). Where does the 55% lump sum penalty apply then?

EdSwippet

Chickereeeee said:

EdSwippet said:

Suppose you are below age 65, have £400k of unused LTA remaining, and crystallise £500k of DC pension. There is no PCLS above the LTA. You would receive £100k (25% of £400k) in PCLS, pay £25k (25% of the excess above £400k) in PCLS penalty, and the remaining £375k moves into drawdown. You then pay income tax at your marginal rate as and when you draw from that £375k.

OK that makes sense (I forgot about no PCLS above LTA). Where does the 55% lump sum penalty apply then?

If you took the complete £100k above the LTA out as a lump sum, rather than placing it into drawdown, you would pay the 55%. Notice that 25% LTA penalty and then 40% higher rate tax on the remaining 75% when withdrawn (25% + 40% of 75%) is also 55%.

Chickereeeee

Ah, ok thanks. I have got it now. And at 75, a 25% LTA penalty on any 'growth' since last crystallisation.
Have anybody any thoughts on whether I should crystallise the lot now, in stages, or wait until LTA reached? Pros/cons?

EdSwippet

Chickereeeee said:

Ah, ok thanks. I have got it now. And at 75, a 25% LTA penalty on any 'growth' since last crystallisation.
Have anybody any thoughts on whether I should crystallise the lot now, in stages, or wait until LTA reached? Pros/cons?

If you crystallise everything now, you preserve some LTA for use at age 75, but you also miss out on some PCLS that you could take much sooner, and when your pension has grown to exactly reach the LTA.

My personal view is that a (relatively) certain 25% PCLS very soon is worth more than an uncertain bit of LTA headroom a decade or two in the future. Particularly since the age 75 LTA penalty can be eliminated by simply drawing down all the nominal gain in the drawdown element before reaching 75. Your circumstance might differ though; for example, I am not planning to use pensions as IHT shelters.

Chickereeeee

Thanks. Yes that is pretty much the dichotomy.

As you say, I would have to drawdown the nominal gain as the Second LTA Test just compares the growth in the SIPP at age 75, with no indexation allowance if all the LTA has been used. If I crystallise 100% now, I lock in 10% of LTA, AND benefit from some CPI increase in the LTA by age 75.

(whether that its worth worrying about I m not sure!)

EdSwippet

Chickereeeee said:

If I crystallise 100% now, I lock in 10% of LTA, AND benefit from some CPI increase in the LTA by age 75.

(whether that its worth worrying about I m not sure!)

You have FP 2016, and this does not rise with inflation. So you will only gain from inflationary rises in the standard LTA once it exceeds the FP 2016 level of £1.25m. At 3% annual inflation, it won't reach that point until around 2025, leaving you around five years of LTA inflation uplift, and maybe fewer, rather than the ten you might currently be imagining.

Also, consider the probability of the government fiddling with (worsening) these pension rules and/or limits again before 2030.

Chickereeeee

EdSwippet said:

You have FP 2016, and this does not rise with inflation. So you will only gain from inflationary rises in the standard LTA once it exceeds the FP 2016 level of £1.25m. At 3% annual inflation, it won't reach that point until around 2025, leaving you around five years of LTA inflation uplift, and maybe fewer, rather than the ten you might currently be imagining.

Also, consider the probability of the government fiddling with (worsening) these pension rules and/or limits again before 2030.

OK, thanks again, Yes I was aware of only 5-ish years,.

I have done the full calculation, now I am clear on the facts, and the answers is: it doesn't make much difference (about £7K) under most assumptions. Crystallising at 100% LTA is slightly more  beneficial, when taking account of FV of £40K in 10 years time.

Added to your last comment, I think leaving until LTA reached makes the most sense.

Very helpful.