Avoiding 60% marginal tax rate

EdSwippet

Pat38493 said:

Being close to the age at which you can crystallise a pension does however give you a potential route to mitigating the worst of the LTA damage, if/when your investments start bubbling up towards it. Once over 55, you can crystallise some or all of your DC pensions and so jump the LTA hurdle (or limbo under the LTA bar; choose your preferred metaphor) before exceeding the LTA. At that point, your next worry is the second forced LTA test at age 75. You do have two decades to prepare for that, though.

For sure but this could also go the other way if the LTA actually goes up in future years and I have crystallised a large % of it already.

Quite right. It could. The aim though is to crystallise exactly at or a smidgen below the LTA. Two thoughts on your comment, then.

One, any rise in the LTA is likely to be inflationary only, whereas you anticipate (hope, expect) your investments will rise faster than inflation. If they do, then you have an LTA penalty which increases, where you might otherwise have entirely avoided it.

And two, simply look at the history of the LTA since it was first foisted on pension savers by the government, and ask yourself what you think is the probability of a meaningful rise in it between now and, say two to three years time, which is when your 80% LTA use might become 100%. Particularly given that it is currently frozen for four years, until 2026.

Pat38493

EdSwippet said:

Pat38493 said:

Being close to the age at which you can crystallise a pension does however give you a potential route to mitigating the worst of the LTA damage, if/when your investments start bubbling up towards it. Once over 55, you can crystallise some or all of your DC pensions and so jump the LTA hurdle (or limbo under the LTA bar; choose your preferred metaphor) before exceeding the LTA. At that point, your next worry is the second forced LTA test at age 75. You do have two decades to prepare for that, though.

For sure but this could also go the other way if the LTA actually goes up in future years and I have crystallised a large % of it already.

Quite right. It could. The aim though is to crystallise exactly at or a smidgen below the LTA. Two thoughts on your comment, then.

One, any rise in the LTA is likely to be inflationary only, whereas you anticipate (hope, expect) your investments will rise faster than inflation. If they do, then you have an LTA penalty which increases, where you might otherwise have entirely avoided it.

And two, simply look at the history of the LTA since it was first foisted on pension savers by the government, and ask yourself what you think is the probability of a meaningful rise in it between now and, say two to three years time, which is when your 80% LTA use might become 100%. Particularly given that it is currently frozen for four years, until 2026.

Understood, but if the investment continues to grow whilst in drawdown, the growth will still end up subject to LTA tax at age 75 as far as I understand?  

I suppose you could then avoid this by putting it in very low growth but highly secure investments as one option.

I guess you then have some complicated tax calculations to figure out whether it makes sense to withdraw the money quicker in order to avoid LTA charges many years down the line.

Grumpy_chap

Pat38493 said:

For sure but this could also go the other way if the LTA actually goes up in future years and I have crystallised a large % of it already.

Ah yes, I see the Daily Snail headlines now - Government solves cost of living crisis by tax break for rich pensioners...

EdSwippet

Pat38493 said:
Understood, but if the investment continues to grow whilst in drawdown, the growth will still end up subject to LTA tax at age 75 as far as I understand?  

It will if you don't take steps to trim it over the years, so that when you reach age 75 you have drawn out all the nominal growth. So you're motivated to do that. And you'll want money to live off anyway. With flexi-drawdown, paying an LTA penalty at age 75 is pretty much voluntary. Take the money taxably instead. Even additional rate tax is below the LTA penalty rate.

Assuming that is that you're not planning to use the pension as a pure IHT bypass. If you are, then you'd act differently. (And of course, you'd also have to worry about the government changing the rules on that with retroactive effects, as well.)

Pat38493 said:
I suppose you could then avoid this by putting it in very low growth but highly secure investments as one option.

Not sure why you would do that. Just keep it in whatever you would have kept it in anyway, but draw down taxably (as above) to keep it pruned so that you dodge the LTA test at age 75.

Pat38493 said:
I guess you then have some complicated tax calculations to figure out whether it makes sense to withdraw the money quicker in order to avoid LTA charges many years down the line.

Even if you do nothing until age 74 and 11 months, drawing out the entire growth then would still beat the alternative. Maximum 45% marginal income tax, compared with 55% if you leave it a month longer.

However, optimising it across two decades would likely beat taking it all right before age 75. That might involve some fiddly spreadsheeting, handling a lot of moving parts, but overall it's pretty clear-cut that you want to have withdrawn all the gains, either gradually or (worst case) in one large last-minute chunk, by then.

There is, by the way, a benefit in having money in the pension to age 75, and that is that the growth is tax-deferred. You'll end up paying tax on it anyway, but while in the pension you don't pay tax annually, so there's a roll-up gain. For what it's worth, if left long enough, that roll-up tax deferral can even overcome the 55% LTA penalty rate. However, it takes a looooong time to reach that break-even point. My projection showed I'd be age 95 before it happens. Any win will be a hollow one at that age. I'm not leaving my pension untouched until then.

Anyway, I think at this point you have enough information to make a sensible decision on this. Because you (nor any of us!) cannot know what rules, allowances, and other nonsense the government will invent, change, or otherwise inflict upon pension savers, nor what markets will do over more than two decades, all you can really go on is probabilities and, up to a point, hunch.

My hunch, based on the past, is that more time equals more adverse government rules for pensions, or at minimum a gradual frog-boiling (along the lines of continued failures to adjust allowances upwards for inflation). Your hunch might be different, and perhaps you are right and I am over-pessimistic. Or maybe you have entirely different priorities to mine. Okay. At least now you can see the potential drawbacks in your original plan.

Pat38493

EdSwippet said:

Anyway, I think at this point you have enough information to make a sensible decision on this. Because you (nor any of us!) cannot know what rules, allowances, and other nonsense the government will invent, change, or otherwise inflict upon pension savers, nor what markets will do over more than two decades, all you can really go on is probabilities and, up to a point, hunch.

My hunch, based on the past, is that more time equals more adverse government rules for pensions, or at minimum a gradual frog-boiling (along the lines of continued failures to adjust allowances upwards for inflation). Your hunch might be different, and perhaps you are right and I am over-pessimistic. Or maybe you have entirely different priorities to mine. Okay. At least now you can see the potential drawbacks in your original plan.

Thanks for the hints and one final point or question.

Your comments above seem to imply that the LTA test at 75 would be subject to 55% tax. However, from a prior LTA thread on the pensions forum here that I followed, and from some articles I’ve just looked up just now, it says that any LTA charge levied under the LTA test at age 75 would be 25%.  In fact, my understanding would be that if you did what you describe above and took all the money as a lump sum at age 74, this is what would then trigger the 55% charge so this would not be a good idea.

Also, in the scenarios described above, we are probably talking about money that was already crystallised into a flexi access plan and then grew further, so it’s already in an income plan.  However either way, I found several articles that categorically state that the LTA test at 75 is always taxed at 25%.

However generally I think your pan makes sense to crystallise the benefits when you reach LTA unless you are looking at IHT topics.

EdSwippet

Pat38493 said:

Your comments above seem to imply that the LTA test at 75 would be subject to 55% tax. However, from a prior LTA thread on the pensions forum here that I followed, and from some articles I’ve just looked up just now, it says that any LTA charge levied under the LTA test at age 75 would be 25%.  In fact, my understanding would be that if you did what you describe above and took all the money as a lump sum at age 74, this is what would then trigger the 55% charge so this would not be a good idea.

I think you are confusing the LTA lump-sum rule with ordinary taxable withdrawals of (part of) a pension's crystallised (drawdown) element.

The second LTA test, forced at age 75, tests both uncrystallised and crystallised funds. For both, the penalty is 25%, followed by regular income tax when you withdraw the remainder. The test for uncrystallised funds is on the entire balance; the test for crystallised funds is on the gain above the amount initially crystallised. Google BCE5A for full details.

The assumption is though that you have entirely crystallised the pension by age 75. So at that age, you could face an instant one-off 25% penalty on all the remaining undrawn gain in the pension, and then regular income tax on withdrawing that. Paying only regular income tax is (nearly always; but see below) better than a 25% penalty and then regular income tax on the remainder.

Maybe an example will clarify. Round numbers for simplicity. Suppose at age 55 you crystallise a pension exactly at a £1m LTA, take the 25% tax free, and leave the remaining £750 untouched for 24 years 11 months (not sensible, but let's say that happens anyway). And suppose by this point it has grown to £850k, so you have £100k of growth. If you withdraw that £100k as ordinary taxable income today (not a "lump sum"), you might pay 40% in tax, leaving £60k. If however you wait a month, you lose £25k in LTA penalty, and then have to pay 40% tax on the remaining £75k, leaving £45k. A £15k loss, 15% of your gains, for failing to manage the age 75 test.

In practice it will likely be better to withdraw growth over time, managed around tax brackets so that gain in the crystallised element is zero at age 75, rather than wait until nearly age 75. However, the numbers are such that even at that point, taking all the growth in one go may well beat paying the LTA penalty.

So yes, some potentially fiddly organisation to make sure that you drain the gains in your crystallised pension before age 75. Perhaps even taking (unneeded) income up to the top of the 20% tax bracket at times, to avoid being pushed into 40% in future as far as possible; although recognising that even 40% now beats a potential 25% + 40% of 75% = 55% LTA rate later.

Pat38493 said:

Also, in the scenarios described above, we are probably talking about money that was already crystallised into a flexi access plan and then grew further, so it’s already in an income plan.  However either way, I found several articles that categorically state that the LTA test at 75 is always taxed at 25%.

Right. I used 55% as a shorthand assumption for a higher rate taxpayer. The actual LTA penalty is 25%, but you also then pay ordinary income tax on the remainder. That combination comes out to 40% for basic rate tax, 55% for higher rate tax, and 58.75% for additional rate tax.

That's not to say that there aren't edge cases where paying the LTA penalty might be the lesser evil. Suppose you work in a high paying job, £200k/year, spend every penny of earnings, and retire at age 75 and 1 month, with zero other income except for pension with £16k in crystallised gains. Taking the £16k before age 75 would lose you 45% in tax, leaving £8.8k. By contrast, paying the £4k in 25% LTA penalty would enable taking the remaining £11k tax-free (below the annual tax-free income allowance). An extreme and unlikely example, but it serves the point.

Or, at the other extreme, suppose you have zero other earnings, and have a pension containing £12k in undrawn gains. Take that £12k just before age 75 and you pay no tax. Leave it until age 75 and you lose £3k to LTA penalty. You can take the remaining £9k and pay no tax on that, but you've just lost £3k, a full 25% of what you could have taken, simply for waiting rather than withdrawing sooner.

Paying a 25% LTA penalty isn't always worse than the alternative, then. But (except for IHT considerations, which we're not talking about), it seems that in most practical cases it is suboptimal. Taking the full gain now at 40% tax say, or waiting, paying 25% penalty, and then taking the remainder at 20% tax are equivalent. To win with an age 75 LTA penalty then, all your post-age 75 withdrawals must be taxed at below 20%. That may be hard to arrange.

biscan25

Pat38493 said:

EdSwippet said:

Anyway, I think at this point you have enough information to make a sensible decision on this. Because you (nor any of us!) cannot know what rules, allowances, and other nonsense the government will invent, change, or otherwise inflict upon pension savers, nor what markets will do over more than two decades, all you can really go on is probabilities and, up to a point, hunch.

My hunch, based on the past, is that more time equals more adverse government rules for pensions, or at minimum a gradual frog-boiling (along the lines of continued failures to adjust allowances upwards for inflation). Your hunch might be different, and perhaps you are right and I am over-pessimistic. Or maybe you have entirely different priorities to mine. Okay. At least now you can see the potential drawbacks in your original plan.

Thanks for the hints and one final point or question.

Your comments above seem to imply that the LTA test at 75 would be subject to 55% tax. However, from a prior LTA thread on the pensions forum here that I followed, and from some articles I’ve just looked up just now, it says that any LTA charge levied under the LTA test at age 75 would be 25%.  In fact, my understanding would be that if you did what you describe above and took all the money as a lump sum at age 74, this is what would then trigger the 55% charge so this would not be a good idea.

Also, in the scenarios described above, we are probably talking about money that was already crystallised into a flexi access plan and then grew further, so it’s already in an income plan.  However either way, I found several articles that categorically state that the LTA test at 75 is always taxed at 25%.

However generally I think your pan makes sense to crystallise the benefits when you reach LTA unless you are looking at IHT topics.

LTA test at 74 gives the option of 25% + income tax, or 55%. At 75, as you say the 55% option is removed, but this isn't necessarily worse if you are a higher rate taxpayer.

Pat38493

EdSwippet said:

Paying a 25% LTA penalty isn't always worse than the alternative, then. But (except for IHT considerations, which we're not talking about), it seems that in most practical cases it is suboptimal. Taking the full gain now at 40% tax say, or waiting, paying 25% penalty, and then taking the remainder at 20% tax are equivalent. To win with an age 75 LTA penalty then, all your post-age 75 withdrawals must be taxed at below 20%. That may be hard to arrange.

OK yes I think this was the same understanding for me I was just a bit confused by your 55% comment earlier.

Also from what you say, if I draw out all of the flexi access money before reaching 75, it will never be subjected to LTA charge even if some of the drawn out money was growth that was achieved in the years running up to 75?  Since the fund is already crystallised it won't be tested at withdrawal until 75?

EdSwippet

For info, the ACCA has an example of how BCE5 operates, and how the LTA penalty can be mitigated. See Example 7:

Lifetime Allowance Charge : Worked Examples -- ACCA

Even here though, there is an error (if you can't trust accountants to get things right, who can you trust?!). The final paragraph should read (the bolded text is my addition):

Bob could have taken steps to reduce the lifetime allowance charge, such as making larger withdrawals from the drawdown pension pot in the years before his 75th birthday. If he reduced the gains in the value of the drawdown pension pot to less than £257,500 there would be no lifetime allowance charge on his 75th birthday, although those withdrawals would be subject to income tax as pension income in the normal way. 

Whether to withdraw gains before age 75 or wait until after and pay the 25% LTA penalty is reducible to a bit of maths. If X is your tax rate now, and Y your post-age 75 tax rate, you should wait until after age 75 if X >= 0.25 + 0.75 * Y, otherwise you withdraw before. Break-even Y = (X - 0.25) / 0.75.

So ... for X = 0 (below the annual tax-free allowance) and X = 0.2 (basic rate tax), there is no solution to this (Y is negative!), and you should always take now rather than wait. X = 0.4 (higher rate tax) requires Y <= 0.2, and X = 0.45 (additional rate) requires Y <= 0.2667.

The difficulty is, as ever, predicting Y into the future. In practice though, you don't need an accurate prediction of a particular value, only a sense of whether or not it will be on average above or below the break-even number.

EdSwippet

Pat38493 said:
Also from what you say, if I draw out all of the flexi access money before reaching 75, it will never be subjected to LTA charge even if some of the drawn out money was growth that was achieved in the years running up to 75?  Since the fund is already crystallised it won't be tested at withdrawal until 75?

Almost. For a DC pension, the LTA test happens when (a) you crystallise some or all of your uncrystallised funds, and (b) you reach age 75. The first of these is under your control, and covers only uncrystallised funds (that is, the amount you're crystallising). The second is forced, not under your control, and covers both any uncrystallised funds and also all nominal growth in crystallised funds.

You can avoid LTA penalties on the first, (a), by timing crystallisation so as to crystallise your pension exactly at the LTA (for optimum tax-free lump sum). For the second though, (b), you have no control on the timing, so instead you have to manage this by ensuring that your nominal gains in the crystallised funds are zero at age 75.

In between (a) and (b) you are free to draw down as much from the crystallised part as you like, with no LTA tests. The age 75 BCE is the only time that pension money is (spitefully) re-subjected to a second LTA test.

So, your statement "if I draw out all of the flexi access money before reaching 75" should really read "if I draw out all of the nominal gains in the flexi access money before reaching 75". Crystallise £1m for £750k in the drawdown part at a £1m LTA (again round numbers for simplicity), and you just need to ensure that the drawdown part is no higher than £750k when you pass your 75th birthday.

You could, of course, arrange that by holding low- or even no-growth assets in the drawdown part, cash at the extreme. However, that would be self-defeating where the alternative is to get some growth or income from this part, but just make sure to draw it (taxably) before age 75. Reducing income to zero is one way to reduce tax, but not usually a winning one.

Finally, notice that the age 75 test on crystallised funds works on nominal amounts. If you have used up 100% of your lifetime allowance crystallising the pension in the first place, and this is the aim, you have 0% of it left to help out at age 75. At that point, even if the LTA has increased with inflation over time, or perhaps even been hugely increased by a less tax-hungry goverment (hah, as if!), 0% of an LTA of any size is still £0. So ... you need to draw the entire nominal gain to avoid age 75 LTA penalties.

Charming, isn't it?