LTA - trying to understand net result of (additional) tax hit

MrBobbins

Partly as a result of the excellent information gained on here in a separate thread about avoiding LTA, I've modified one of my prediction spreadsheets to try to put some figures on how beneficial early crystallisation (to delay hitting LTA) really is. 

I've looked at an example annual gross withdrawal of £40K from my pension, to see what my net income would be if this was taken either before or after hitting LTA limit (I realise the actual "after LTA" hit would be late in my retirement, and the personal allowance will almost certainly have changed by then but I'm trying to keep this simple). 

Here's what I came up with. I'd be grateful if people could let me know if my calculations are sound, show a fundamental misunderstanding, or somewhere inbetween...
I've rounded the personal alowance down for cleaner numbers, and I'm assuming no other income, so can make use of personal allowance, and also remain a standard rate tax payer.

Before hitting LTA

£40K withdrawal or taken as income over year (I think there'd be no differerence for tax?)

Divided into £10K (25%) tax free and £30K (75%) taxable, so ...

No tax part: £10K  + £12K personal allowance.
Taxed part is remaining £18K, so £18K taxed at 20% is £14.4K
Total net income therefore £10K + £12K + £14.4K = £36.4K meaning an overall equivalent tax of £3.6K or just under 10%

After hitting LTA

£40K taken as income over year, so first hit by LTA tax of 25%, therefore leaving...

£30K. 

25% tax free all used up now, so tax free part is simply the £12K Personal Allowance.
Taxed part is remaining £18K again so £18K taxed at 20% is £14.4K
Total net income therefore £12K + £14.4K = £26.4K meaning an overall equivalent tax of £13.6K or 34%


I was rather surprised to see that the LTA therefore seems to have the effect of losing 25% of the gross value (£10K here) off the net!

Now nervously awaiting the "you've completely misunderstood how this works" reply!

EdSwippet

MrBobbins said:

I was rather surprised to see that the LTA therefore seems to have the effect of losing 25% of the gross value (£10K here) off the net!

I'm surprised that you're surprised at the final outcome, since the LTA penalty is by definition 25% of the amount above the LTA that is crystallised.

If it helps, think of things this way:

• Below the LTA, you get 25% tax free, and you pay income tax on the remaining 75%.
• Above the LTA, the government takes what would have been your 25% tax-free all for itself, and you still pay income tax on the remaining 75%.

For amounts below the LTA then, the pension wrapper is a tax benefit. Above, it is a tax curse.

MrBobbins said:

Now nervously awaiting the "you've completely misunderstood how this works" reply!

Not completely misunderstood. However, your numbers are somewhat at odds with "Before hitting the LTA" and "After ...". Specifically, your first numbers describe what happens when you make a withdrawal from the SIPP and still have some unused LTA percentage, so arguably perhaps your early retirement years. Your second numbers show what happens once you have exhausted your LTA percentage headroom, so you would only see that once you have spent down £1mm or so of pension money that falls under the LTA. Depending on your spending and withdrawal rates, you might not reach this point, in which case it becomes something your heirs have to contend with instead.

Really though, you should be thinking instead not about future withdrawals, but rather about present asset placement. By taking money out of your pension early, and assuming your funds will grow over time (and you'd hope so!), you jump the LTA hurdle -- or duck under it; pick your metaphor! -- with a lower or ideally zero LTA penalty, and the 25% PCLS withdrawn and the remaining 75% drawdown elements can stay invested in the same things as now, but with a lower overall tax on their growth in future, because the LTA test is in the past.

... well, except for the spiteful vexatious age 75 test on drawdown funds, but you neutralise that by simply withdrawing enough taxably to ensure that your drawdown balance at age 75 is no higher than the amount crystalllised into it some years or decades earlier.

Others will now arrive to again state (with some justification) that for the average case, the LTA penalty is not punitive, and merely cancels out previous tax relief. However, yours may not be an average case. And even if it is, then depending on circumstances, crystallising early can still be an improvement, since it may allow you to mitigate some or all of this LTA cancellation of previous tax relief.

zagfles

Why are you so surprised that LTA tax of 25% loses 25% of the value? The gross loss is the same as the net because you also lose the right to any more tax free cash once over the LTA, which is also usually 25%, so the gross hit is the same as the net hit. Effectively the taxman takes your 25% tax free cash once over the LTA.

ex-pat_scot

In general terms, it seems the best way to play the LTA game is broadly as follows:
- crystallise as early as possible.
- take up to the top of Basic Rate band, whether required or not, and use ISA (or unwrapped account) to store any surplus beyond your spending requirements.
- growth once crystallised is better in your ISA than in your pension, so think about derisking the pension and taking growth risk in non pension assets.

If your only source of income from 55 is your pension, then you can take out £66,666 gross each year (£59,166 net or £4,930 per month) at the top of the BR band, and pay a total of £7,500 tax. 
This will hopefully outpace any net growth in your pension, so that by 75 you don't get hit by the BCE75 nasty test.

Clearly if you have income (or income generating assets) outside of your pension, then you won't have quite so much capacity to deplete the pension without tiptoeing into HR tax band. 

Albermarle

 well, except for the spiteful age 75 test on drawdown funds, but you neutralise that by simply withdrawing enough taxably to ensure that your drawdown balance at age 75 is no higher than the amount crystalllised into it some years or decades earlier.

A pension is to provide an income in your retirement, and the reason that the government is so generous with tax relief etc is to help you do that .

If you are wealthy enough that you can build up a very large pot and not actually have to use it to provide an income , then I see a test at 75 having some logic . It only really hurts people who are not taking enough income from their pension,( which is the whole idea of a pension in the first place)  and presumably trying to use it as a way of avoiding IHT .

Others will now arrive to again state (with some justification) that for the average case, the LTA penalty is not punitive, and merely cancels out previous tax relief. 

You beat me to it !

shortseller09

ex-pat_scot said:

If your only source of income from 55 is your pension, then you can take out £66,666 gross each year (£59,166 net or £4,930 per month) at the top of the BR band, and pay a total of £7,500 tax. 

Would you mind clarifying your calculation?

zagfles

ex-pat_scot said:

In general terms, it seems the best way to play the LTA game is broadly as follows:
- crystallise as early as possible.
- take up to the top of Basic Rate band, whether required or not, and use ISA (or unwrapped account) to store any surplus beyond your spending requirements.
- growth once crystallised is better in your ISA than in your pension, so think about derisking the pension and taking growth risk in non pension assets.

If your only source of income from 55 is your pension, then you can take out £66,666 gross each year (£59,166 net or £4,930 per month) at the top of the BR band, and pay a total of £7,500 tax. 
This will hopefully outpace any net growth in your pension, so that by 75 you don't get hit by the BCE75 nasty test.

Clearly if you have income (or income generating assets) outside of your pension, then you won't have quite so much capacity to deplete the pension without tiptoeing into HR tax band. 

If you've "crystallised as early as possible", then how can you take out £66,666 without going into higher rate tax? If you've crystallised then you've taken all your tax free cash, so everything you take from the crystallised pot is taxable. So you can only take £50,270 before entering higher rate tax.

EdSwippet

Albermarle said:
If you are wealthy enough that you can build up a very large pot and not actually have to use it to provide an income , then I see a test at 75 having some logic . It only really hurts people who are not taking enough income from their pension,( which is the whole idea of a pension in the first place)  and presumably trying to use it as a way of avoiding IHT .

Yeah, somewhat. In the days before flexi-drawdown, and under capped drawdown, that age 75 BCE test would likely have had real teeth. Capping drawdown could very well mean that you had no way of avoiding an(other) LTA penalty once you hit that age.

With flexi-drawdown though, it is at least relatively easy to avoid LTA penalties once you reach age 75, and provided you see the penalties coming. Outside of IHT finagling, is hard to conceive of a scenario in which paying the LTA penalty then withdrawing after age 75 beats withdrawing all the real and nominal gain before age 75.

That's not to say that it's entirely benign, though. It's a ridiculously blunt instrument, and it effectively forces withdrawal of inflationary gain as well as real gain, so that you end up paying tax on inflation. (Sure, that occurs elsewhere too, but that doesn't make it right.) And in some cases, in tandem with inflation it could deplete pension funds on the cusp of where they might be most useful for care home or other old age care, so in that sense it could end up being somewhat self-defeating.

Perhaps "vexatious" covers things rather better than "spiteful"?

zagfles

Albermarle said:

 well, except for the spiteful age 75 test on drawdown funds, but you neutralise that by simply withdrawing enough taxably to ensure that your drawdown balance at age 75 is no higher than the amount crystalllised into it some years or decades earlier.

A pension is to provide an income in your retirement, and the reason that the government is so generous with tax relief etc is to help you do that .

If you are wealthy enough that you can build up a very large pot and not actually have to use it to provide an income , then I see a test at 75 having some logic . It only really hurts people who are not taking enough income from their pension,( which is the whole idea of a pension in the first place)  and presumably trying to use it as a way of avoiding IHT .

Others will now arrive to again state (with some justification) that for the average case, the LTA penalty is not punitive, and merely cancels out previous tax relief. 

You beat me to it !

AIUI the LTA tax rate was supposed to broadly cancel tax relief based on 40% relief and 40% tax in retirement, the 55% rate (both lump sums and the 25% drawdown rate compounded with 40% tax on income drawdown) supposedly to account for tax free growth. Because originally back on A-day (2006) with a much higher LTA and a much lower higher rate threshold it was virtually impossible to exceed the LTA and remain a basic rate taxpayer in retirement if you drawdown your pot over retirement.

Now with the LTA cut so much and the HRT increased, you can exceed the LTA a fair bit and remain a basic rate taxpayer in retirement with a reasonable drawdoiwn rate.

So it's certainly not punitive for those who get higher rate relief and pay basic rate in retirement. In fact it's probably been used as an alternative to the constant calls to scrap higher rate relief on pensions, it achieves similar for those who've benefitted from a lot of higher rate relief.

EdSwippet

zagfles said:

So it's certainly not punitive for those who get higher rate relief and pay basic rate in retirement. In fact it's probably been used as an alternative to the constant calls to scrap higher rate relief on pensions, it achieves similar for those who've benefitted from a lot of higher rate relief.

Indeed. I don't see anybody arguing that the LTA is existentially punitive in every case.

It is however indisputably punitive in some cases. Including where you do not drop at least one marginal tax bracket on retirement, and also when the counterfactual is failing to (or being unable to) engage in early crystallisation of the pension so that the LTA penalty is entirely avoided.

I'll also argue that the LTA's repeated reductions and its lack of inflation indexing are punitive, in that they hit pension saving that might not have been entered into had the LTA been lower at the time they were made; that is, with retroactive effects. The assorted protection regimes only partially compensate. 

MrBobbins

EdSwippet said:

If it helps, think of things this way:

• Below the LTA, you get 25% tax free, and you pay income tax on the remaining 75%.
• Above the LTA, the government takes what would have been your 25% tax-free all for itself, and you still pay income tax on the remaining 75%.

Thanks - that's a clear way seeing it I was grasping for but hadn't quite found!