The lifetime allowance – A reminder
The lifetime allowance charge occurs when over 100% of an individual’s lifetime allowance is used up in the process of crystallising benefits. Crystallisation occurs at the point a client wants to access their pension and is called a Benefit Crystallisation Event (BCE). Each BCE will use a percentage of the lifetime allowance and it is only at the point the 100% is breached that a charge will apply. In an individual’s lifetime this charge will usually be made on the scheme, although it is still a requirement for the individual to declare the charge on their self-assessment return.
What is the difference between the 25% and 55% charges?
Usually when we discuss the charge we talk about the 25% charge, this is because the 55% charge is only payable when you take the excess out as a lump sum. When the charges were brought into existence, the highest rate of income tax was 40% and it was assumed that if an individual had a lifetime allowance charge that they would be a higher rate taxpayer and this is where the 55% comes from.
If taken as income the client would pay the 25% charge and then the residual funds, which fall within the higher rate band, would be subject to 40% income tax when drawn. If the client takes a lump sum, then the only charge is the 55%.
£100,000 excess, is reduced to £75,000 after the lifetime allowance charge of 25%. When this £75,000 is taken out and income tax at 40% is charged the individual is left with £45,000.
If the £100,000 is drawn directly as an excess lump sum, then the 55% charge would leave the client with £45,000 in their pocket.
However, not all those with lifetime allowance charges are higher rate taxpayers, and we also now have a 45% tax rate for additional rate taxpayers, which means it can be beneficial in some cases to take a lump sum over an income, although this is generally quite rare. We also have to remember that when taking an excess lump sum then the client is bringing funds immediately into their estate for inheritance tax assessment purposes, so this still may not be the most appropriate course of action.
Can I always choose which level of charge is most appropriate?
No, the charge is dependent on the way in which the excess is crystallised, either as income or paid out as a lump sum.
At the age of 75 clients don’t get to choose what happens, it is a default BCE and the 25% charge occurs. Should the client want to take the excess out as a lump sum at this point, either a BCE needs to be triggered before age 75, or they just draw the excess as income immediately after the age of 75 incurring their tax rate based on their total taxable income as normal under PAYE.
Are there any differences on death?
Death restricts the choices even further. Firstly, there is no option to choose what order BCEs occur in, they all happen simultaneously, across all of the client's plans, with the remaining lifetime allowance shared amongst all the BCEs that are occurring. This means that if there is a charge then all the beneficiaries will have to pay a share of it, proportionately. The charge is also not paid by the scheme but by the beneficiary themselves once all the calculations have been made.
Some death benefit options can only be paid as a lump sum, such as death in service benefits and these will be subject to the 55% tax charge. This generally seems unfair, because, if the benefit were payable as an income, there wouldn’t be any income tax charge in addition to the 25% lifetime allowance charge. This is a hangover from when income tax was payable by beneficiaries on all death benefits and there isn’t any way to avoid this, unless the Death in Service (DIS) scheme allows the excess funds to be used to provide a dependant's pension instead. .
It is good practice to investigate what options are available on death, especially where a lifetime allowance charge may be payable, because not all schemes will be able to offer an income to the beneficiary, meaning the higher lifetime allowance charge would be applicable.
The lifetime allowance charge and how it works is a very important part of pension planning, but it shouldn’t be considered in isolation. We always need to take account of the bigger picture and the client’s personal circumstances, such as the implications of bringing excess funds into the estate or providing continued tax-free growth on the remainder of the assets after any lifetime allowance charge is applied.
If you’re planning on protecting your lifetime allowance or want the pension lifetime allowance explained further, please get in touch with The Private Office today.
The information in this article is correct as of 23/08/2022.