In this article we look at the key planning points to consider when deciding whether to draw (crystallise) personal pension funds to avoid an immediate LTA charge.
For those without protection the Lifetime Allowance will be set at £1,073,100 until April 2026, a far cry from the £1.8m in 2011/12, and as a consequence, will mean more and more individuals will become liable to the LTA Charge. This is payable when funds above the LTA are crystallised, or age 75, whichever is sooner. The LTA charge is paid on values above the LTA, at a rate of 25% if funds are kept in the pension and crystallised as an income (although you do not have to take an income, but the charge is still levied), or 55% if drawn as a lump-sum.
For those over the minimum retirement age with large defined contribution (personal pension/SIPP) funds near or in excess of the LTA, the decision regarding when to crystallise can be complex.
Choosing to crystallise funds earlier can avoid or reduce the LTA charge and the LTA freeze announced in the Spring 2021 Budget may make this appear a more attractive option. Leaving the funds will no longer offer the inflationary protection of the LTA or increases in the maximum tax-free cash available over the medium term.
However, there are a number of factors that also need to be considered, including the second LTA charge at age 75 or earlier annuity purchase, when pension values are tested again. Many individuals are surprised by this. Just to explain, if you crystallised 100% of your LTA, then any growth on the pension in excess of income earned will be liable to an LTA charge at age 75. Equally, any pensions funds not crystallised above the LTA will incur a similar charge.
In addition to any LTA charges, when considering to crystallise you must also consider your income needs, your income tax position, and any inheritance tax (IHT) consequences, along with wider estate planning objectives.
There are two broad options when considering when to crystallise:
- Crystallise the funds immediately.
- Leave the funds uncrystallised until they are needed, or until age 75.
There are of course variations within these options such as to partially crystallise or to crystallise up to the LTA if the funds exceed the LTA. However, these options demonstrate the key differences in terms of the planning considerations.
Where you are over minimum pension age, currently 55, you can choose to crystallise the funds at any point. This would usually involve taking the tax-free cash amount and moving the rest of the fund into drawdown.
This option can avoid an immediate LTA charge. Even if the funds already exceed the LTA you can crystallise up to the value of the LTA. However, there are other important considerations:
- Where the fund value is less than the LTA you will not have maximised your tax-free cash entitlement. For example, if the fund is worth £1m, the tax-free cash entitlement is £250,000 which is £18,275 less than the maximum. The only way to receive the maximum tax-free cash would then be to make further contributions. Waiting until the point the fund value reaches the LTA will resolve this issue.
- The tax-free cash is removed from the tax efficient wrapper if the pension fund and so, if invested, is exposed to income tax and capital gains tax (CGT).
- The tax-free cash sum now falls into your estate. If there is no immediate need for this it is now exposed to a potential 40% tax charge on death, whereas it could have remained outside of the estate (so to avoid IHT) within the pension fund. The maximum tax-free cash is £268,275 with the standard LTA. Taking this could result in additional IHT of £107,310.
- Crystallising the funds now allows you to control any LTA charge at the point of the second LTA test at age 75 or earlier annuity purchase. However, this will require taking any growth on the drawdown fund as income withdrawals. These will be subject to income tax at your highest marginal rates in the tax year it is received. A key consideration will be if and when you are likely to need any income from the funds and whether it can be taken at more preferable lower marginal rates of income tax at some point in the future.
- If no income is taken then the crystallisation simply removes the tax-free cash element from the calculation with the potential IHT downsides outlined above. Any growth on the funds in drawdown will still be subject to the second LTA test.
- Crystallised funds are not subject to a further LTA test on death before age 75. This can provide an LTA advantage over leaving the funds uncrystallised.
Leaving funds uncrystallised until required or age 75
An alternative option would be to leave the funds invested and not crystallise until funds are required, or at age 75 when all uncrystallised funds are tested against the LTA.
With this option you do not aim to control the LTA, but just accept that it may apply.
The key considerations here are:
- No funds are removed from the tax efficient pension wrapper or brought into the estate unless they are needed.
- You can use other investments to fund any income shortfalls, particularly during the early years of their retirement to reduce the value of your estate.
- If income is only taken when required then it is less likely to suffer higher rates of income tax.
- Whilst there is likely to be an LTA charge, the advantage of this is that the funds all remain outside of the estate for IHT purposes.
- If you have no need for the excess funds above the LTA, you can leave the funds in the pension, suffer the 25% LTA charge at age 75 and leave the funds to pass on to your beneficiaries on death free of IHT (although potentially subject to income tax on withdrawal).
- You can of course monitor and review this strategy at any point. If you need to access the tax-free cash and or income before age 75, you can decide at that point whether to crystallise all the fund or just take up to the LTA at the time.
- The full value of the uncrystallised funds will be subject to an LTA test on death before age 75. However, where beneficiary’s drawdown is used, once the 25% LTA charge is paid the benefits are free of further tax.
- If funds haven’t been taken at age 75, you will need to review the decision as to whether to take the tax-free cash entitlement. Whilst this remains beyond 75, the funds all become taxable on death. Taking the tax-free cash, may however, mean it is subject to 40% IHT.
Freezing the LTA has removed an advantage of leaving funds uncrystallised. However, this remains a complex area of planning and in each case, you need to consider your individual circumstances. This will include your need for income from the pension, your marginal income tax rates both now and in the future and your IHT position. Although planning can help minimise or remove an LTA charge, sometimes accepting the charge may provide the better outcome. Estate planning in particular, has become an increasingly important aspect of pension planning and the advantages provided by a pension plan can outweigh the disadvantages of an LTA charge.
This is a complex area of advice, and needs to be considered holistically.
Should you wish to consider and weigh up your own choices then please get in touch quoting LTA Decision and e-mail email@example.com
Credit – Techlink