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 (but still potentially subject to the second LTA test -- see below). The money can be taken at any point from the drawdown fund and is taxed as income on the taxpayer when it is taken. The tax free element and what is left in drawdown is compared to the LTA at the time of the crystallization 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. Any amounts not yet crystallised are crystallised at this point.The government then tests any increase in the value of drawdown funds since there were created, ignoring the tax-free cash. Where there is more than one drawdown plan, 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%.

An example

For most people the Benefit Crystallisation Events (BCE) that matter are the one that happen upon creation of a drawdown (BCE 1 using DWP terminology) and that measures the market value of what is transferred into drawdown. And the one that happens when reaching 75 years of age (BCE 5A) and that measures the growth in the drawdown pension pot since the member originally entered drawdown. The growth in the value of the drawdown pot is measured against the individual’s remaining lifetime allowance and the excess if any is subject to the lifetime allowance charge.

To better understand how the LTC (lifetime charge) is calculated upon crystallisation, it's best to look at an example:

Sam entered into drawdown in 2010 when the lifetime allowance was £1,800,000. He took 25% of his £1,350,000 pension pot as a lump sum (£337,500) and the remaining 75% (£1,012,500) was invested in drawdown, this used up 75% (£1,350,000/£1,800,000) of his lifetime allowance.

In 2018 Sam was 75 years old. In the period since 2010 Sam has not made any further payments into his pension scheme, he has made some withdrawals from the drawdown pension pot and the investments in the pot have grown in value so on his 75th birthday the drawdown pot is valued at £1,400,000. This is an increase in value of £387,500 from 2010 (£1,400,000 less £1,012,500).

The lifetime allowance on Sam's 75th birthday is £1,030,000. As Sam still has 25% of his lifetime allowance which is still available £257,500 (£1,030,000 x 25%). The lifetime allowance charge is (£387,500 less £257,500) at 25% which is £32,500.

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. 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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