For those with larger pension funds, the LTA (Lifetime Allowance) is a common concern. In this post, we consider the key issues surrounding pension drawdown fund testing against the LTA. Remember, although pension drawdown does offer real benefits to some individuals it also carries risk.
What Is The Lifetime Allowance (LTA)?
The lifetime allowance limits the amount withdrawn from a pension fund. Withdrawing more than the LTA from a pension during retirement will trigger an additional tax charge.
The current (tax year 2017/18) lifetime allowance (LTA) limit is £1,000,000. Any amount taken from a pension fund as income above the LTA are taxed at the pension holders margin tax rate plus a further 25 percent. Above the LTA limit, pension lump sums are taxed at 55 percent rate.
As an example, assume an individual still to retire has no previous drawdown arrangements. They have taken no lump sums or pension income and have a pension fund of £1,250,000
They take the fund into drawdown (a BCE – Discussed below) exceeding the LTA by £250,000. On entering drawdown no tax is payable on £1,000,000 (the LTA). However, tax will be payable on the £250,000 dependant on how the individual intends to take this amount.
If the £250,000 is taken into drawdown to provide a pension income a 25% tax is applied (leaving £187,500 to go into the drawdown fund). If the £250,000 is taken as a lump sum a 55% tax rate is applied.
Drawdown And LTA Trigger Events
Benefit Crystallisation Events (BCE’s) include taking a pension fund into drawdown, purchasing an annuity or taking a pension lump sum. There are many classifications of BCE’s, each relating to a specific event. BCE’s are all defined and administered by HMRC.
If an individual has a pension fund of £950,000. Once over 55 years old they may take 25 percent (£237,500) tax free and place the balance in a drawdown fund. The lump sum and the balance of the fund are two separate BCE’s so the lump sum uses 23.75 percent of the LTA.
The balance of the fund (£712,500) in drawdown is a second BCE using 71.25 percent of the LTA. Using up, in total, 95 (23.75+71.25) percent of the LTA. In this example, no LTA charges will apply but there will be a further test against the LTA at age 75 (see below)
The lump sum is a one off event. Any income taken from the drawdown pension is a BCE measured against the LTA.
If, in the above example, the pension holder takes a further £150,000 into drawdown. This is a further BCE measured against the LTA. Only 5 percent of the LTA remains (£50,000) hence £100,000 is taxable according to the LTA tax charges outlined above.
Second LTA Test When Pension Holder Reaches 75 Years Old
There is a second Lifetime Allowance calculation when an individual reaches age 75. With the calculation based on the amount remaining in the drawdown fund.
The taxable sum is the difference between the amount in the drawdown fund and the amount originally taken into drawdown. Obviously, if the amount remaining in drawdown is lower than the original sum no LTA charge applies.
If the amount in the drawdown pension fund has grown it is tested against any remaining LTA. A 25% tax charge applies to any excess.
The rules surrounding the Lifetime Allowance are complex and the above is much simplified to give a general overview of the process. If the lifetime allowance is a potential issue it is important to take professional advice.
All statements concerning the tax treatment of products and their benefits are based upon our understanding of current tax law and HMRC practices both of which are subject to change in the future. Levels and bases of reliefs from taxation are also subject to change, and are dependent on your individual circumstances’ and ‘The purpose of this post is to provide technical and generic guidance and should not be interpreted as a personal recommendation or advice.