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UK Pensions are great for the tax breaks that they give as you pay into them (up to 45%), and as the pension generates value, but if you exceed the lifetime allowance (LTA = £1,055,000 in 2019-2020) it seems you'll get clobbered with taxes. (A nice problem to have admittedly)

As I understand it, after the LTA, HMRC will charge 55% on lump sum withdrawals, and 25% on income (on top of the ordinary income tax from taking the pension as income), which surely means you would have been better off investing that excess money in anything other than a pension.

So assuming my pension has passed the half way mark to the LTA and I have 20 years left before retirement age, at what funding level does it become poor tax planning to keep paying into the pension? (given the assumption that the pension will continue accumulating value regularly)

And what are the best alternative investments I could make when (or before) I reach that pension fund level? Property, ISAs and VCTs are interesting options, but does one in particular stand out in the circumstances, or should I look at anything else?

  • It's difficult to answer the question as phrased in paragraph 3 without a bit more detail e.g. how long have you been paying in so far, what kind of performance to date? Is it all Defined Contribution or do you have any Defined Benefit? Also, I'm guessing the answer is 'yes' because you said 20 years to retirement, but for clarity, are you over 40 therefore ineligible for Lifetime ISA? – marktristan May 28 at 8:10
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    @marktristan there’s no defined benefit or final salary scheme here. This is a SIPP that has sometimes gained 24% in a year and sometimes lost value, maybe averaging gains of 12% annually in the long term. I’ve beem paying into it for 20 years. It used to be a standard pension before transferring it to a SIPP. I recently slowed my payments right down due to the concern it would exceed the LTA on its own over time. I am over 40. – Sterl42 May 30 at 5:41
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Your question about when it makes sense to stop paying in depends on three things:

  • The possible growth rates of your investments.
  • The costs of going over the LTA.
  • The benefits when under the LTA, which translate into lost opportunity to benefit if you undershoot.

It's really hard to make a good guess about growth rates, so I won't try, and instead focus on the other two points.

Going over the LTA

Firstly, actually going over the LTA isn't necessarily that bad, depending on your marginal tax rates at the time of paying in and the time of taking the money out. One quite common case will be that you are a 40% taxpayer now, and you would be a 20% taxpayer when you take the money out.

Then if you pay in £1 now, it costs you 60p from your after-tax salary. Suppose it grows by some factor due to investment growth. The actual number doesn't matter, so pretend it's 3, i.e. you have £3 when you come to take the money out, and it's all over the LTA. Then you pay 25% penalty leaving you with £2.25, and then 20% tax on the remainder which is 45p, leaving you with £1.80. That's exactly what you'd have if you'd taken the 60p net pay, put it in an ISA and invested it the same way.

In most cases paying the 55% penalty for a lump sum doesn't make sense: it's equivalent to paying the 25% penalty and then 40% income tax. Given the 2016 pension freedoms, you can also get a "lump sum" by just using normal income drawdown. If you're so rich in retirement that you're earning over £100K then perhaps the 55% penalty is a better choice :-)

Things look worse if you are a 20% taxpayer now, or would be a 40% taxpayer when taking the money out.

On the other hand, they look better if you are a 45% taxpayer now, or you are stuck in one of the weird marginal tax bands between £50,000 and £60,000 if you are subject to the child benefit charge, and between £100,000 and ~£125,000 where the personal allowance is withdrawn. Because of the effects of the extra charges, your marginal tax rate is higher than 40% so it often makes sense to make pension contributions to get your taxable income down to the bottom of those bands.

Another possible mitigating factor for the LTA is the timings of the tests against the allowance. This is really complicated and I'm still not sure I've got the rules right. But I think that if your pension reaches the LTA after you reach minimum retirement age (likely to be around age 58 for you - from 2028 the government is planning for it to be your state pension age minus 10), then you can immediately stop paying into your pension and put it into drawdown. Then as long as you withdraw any future growth by age 75, keeping the balance under the LTA, you won't get charged any penalties, if I've understood the rules correctly. I talked about them a bit more in this answer.

Pension benefits when under the LTA

For any money under the lifetime allowance, you can take 25% tax-free, and the rest is taxed as income. So for example using the same example as above, a £1 gross contribution becomes £3. You get 75p tax free and pay 20% = 45p in tax on the other £2.25, leaving you with £2.55 instead of the £1.80 you'd have from an ISA. That's a gain of 5/12ths (~42%). If you put the money elsewhere and it turns out you undershot the LTA, you've given up that gain.

Summary

This table shows the various outcomes from saving £1 of gross salary, depending on your income tax rate when you put the money in and the rate when you put it out. This time I've ignored investment growth completely because as above, it just scales everything by the same amount (note that this isn't the case if you don't use a vehicle where the actual growth happens tax-free - e.g. you just invest money directly).

I've included Lifetime ISAs for completeness even though they don't apply to you.

Tax in | Tax out | Under LTA | Over LTA |  ISA | LISA
-----------------------------------------------------
40%    | 20%     | 85p       | 60p      |  60p |  75p
20%    | 20%     | 85p       | 60p      |  80p | 100p
40%    | 40%     | 70p       | 45p      |  60p |  75p

Finally, the lifetime allowance is now increasing with inflation, so you should be thinking about returns in excess of inflation when you project when you would exceed it. But of course, who knows what a future government might do.

  • Excellent explanation thanks, maybe it is worth using up all the Lifetime Allowance regardless of the risk of going over, after all. I like the comparison to an ISA. It seems the 55% tax on lump sums is still harsh though compared to being tax free normally, or to an ISA, as the same £1 invested after a 3x increase and the tax deduction leaves me with £1.35, so that's a consideration in the decision. – Sterl42 May 31 at 13:25
  • I don't quite know why the 55% is so high, but my sense is that you should just never take that route - instead always take the 25%+income tax. 55% is equivalent to 25% and then 40% income tax (£1 -> 75p -> [40% tax = 30p] -> 45p). – Ganesh Sittampalam May 31 at 14:13
  • The normal minimum age for starting to take a personal pension doesn’t rise to 10 years below state pension age until 2028. Before then, it remains at 55 despite increases in the state pension age. – Mike Scott Jul 7 at 11:01
  • @MikeScott - thanks, googling around it seems the 10 years gap isn't even set in stone yet, just a rough plan. I've edited. – Ganesh Sittampalam Jul 7 at 13:21
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Simple mathsy answer:

You say you’re past half way to the lifetime allowance which is £1055K – let’s assume that means you’ve got £550K, and you make 12% a year – not bad!

Years = LOG(lifetimeAllowance/currentValue, 1 + yearlyIncreasePercentage/100)
 = LOG(1055000/550000, 1.12) 
 = 5.74 years until you pass £1055000 without contributing a penny.

If you went for a more conservative rate, say 3% per year that would be

LOG(1055000/550000, 1.03) = 22 years.

A fixed rate clearly doesn’t take into account the fact that there will be good years and bad years and you may be scared of a stock market crash nearing retirement, and start moving investments somewhere safer with less return.

We also don’t know what will happen to the lifetime allowance – it seems it just increased from one million, but some will tell you the government wants to cut it to £800K. They may be right, or maybe they're scaremongering if they will benefit from you contributing more in the short term.

I’m not clear just how bad it is tax-wise if the pension grows above and beyond the lifetime allowance independent of contributions. Compared to, say, having invested the same cash in an ISA or a fund that’s subject to tax. Gut feeling is the bigger pension can’t be bad, but who knows?

  • Thanks for the maths @robin, it does make me think I’m right to stop contributing for the time being. It still leaves the question of whether now every possible investment type is better than the pension for tax purposes. – Sterl42 May 31 at 6:54

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