Monday, September 9, 2019

Pensions: the Lifetime Allowance time bomb

With rates at historical lows, with $9.5 trillion worth of government debt carrying negative yields and with governments around the world addicted more than ever to Quantitative Easing, fiat money around the world is losing its value faster than ever. It means that the value of a pension fund invested in hard assets (and yes Bitcoins are also an option...) is more susceptible than ever to go over the The Lifetime Allowance (LTA) at some point. Indeed, you just need an 8% annual return over 20 years to multiply the value of your pension by a factor of 5!

The Lifetime Allowance (LTA) is the overall limit a pension plan can reach before its owner is being penalised by a 55% tax upon withdrawal. The Lifetime Allowance after having reached £1,800,000 in 2011/2012 was reduced all the way down to £1,000,000 in 2016/2017 and stayed there for a couple of years before starting to increase again with the CPI (consumer price index) in 2018/2019. It is now at £1,055,000 (2019-2020).

The government tests your pension against the LTA when you take a benefit (eg you take a drawdown or an annuity) or when you reach the age of 75. It's called a benefit crystallisation event (BCE). Nowadays, the most popular way to extract money from a pension is through flexible drawdowns. When take your benefit via a drawdown, 25% of the drawdown is tax free cash and the rest goes into drawdown mode where it can continue to be reinvested tax free. The money can be taken at any point from the drawdown pot and is taxed as income on the taxpayer when it is taken. The drawdown amount (including the cash free element) is compared to the LTA at the time of the drawdown and the corresponding percentage is added to the ones from the previous drawdowns. If you end up over 100% then the additional amount above the current LTA is either taxed at 55% if you take if out of the drawdown pot immediately or 25% if you leave it there (and it will be taxed a second time as income when you take the money out of the fund).

There is a second test when you reach the age of 75. The government tests any increase in the value of the drawdown fund since it was taken, ignoring the tax-free cash. And if someone has more than one drawdown plan at age 75, each plan is tested separately. The charge is based on the total of any increases in drawdown values, ignoring any plans that have decreased in value. There is no opportunity to mitigate any charge by offsetting a ‘loss’ on one drawdown plan with a ‘gain’ on another. Also, any funds that have not been crystallised yet are then crystallised. And the excess above the LTA is then taxed at 55%.

So what are the options to avoid this surcharge?

If you are younger than 55, the only option really is to stop voluntary contributions and make sure you instead max out your ISA (and your partner's) every year. While the ISA provides no tax benefit upfront, it also provides tax free appreciation of your assets and there is no tax upon exit. The only downside of an ISA is that it does not allow you to invest in Bitcoin (yet).

If you are older than 55, you can start taking benefits from your pension. Using drawdowns, you are able to extract the 25% tax free element and leave the crystallised drawdown into the pension to appreciate tax free and/or provide (taxable) income throughout the years. Since any income taken out of the drawdown pots decreases their value, extracting money progressively to avoid higher rate bands will allow you to also avoid the extra tax charge at 75.

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