4

I've been reading about pensions and specifically the LTA (Life Time Allowance), and after spending days reading everything anyone has to say about it, the only thing I'm sure of is that there are many pension administrators/trustees and various other news/journal websites who at least seem to have different ideas about how the LTA works.

  • Some seem to suggest that the (now £1 million) LTA limit is checked against the value of your pension pot when you start drawing it.
  • Some suggest that the check against pension pot value is done every time you draw.
  • Some suggest the realised value of your pension benefits (i.e. accumulated payouts) is checked against the LTA, so you pay the extra tax on any and all income drawn after exceeding the limit.
  • One website I found said there were NINE different points at which the LTA check was performed, where as most list just a one or two, though never saying their list is complete!

Unfortunately whilst the online information published by pension administrators is usually quite tough to assimilate and generally less clear than I would like, my best interpretations of many of these have lead me to believe that all the above evaluation criteria are being variably illustrated.

Does anyone know what the answer is here?

  • Can you just wait until March when the new budget is announced and read the text of the new law with a (supposedly) lowered limit that is (supposedly) linked to inflation? – davmp Jan 28 '16 at 14:01
  • Err, yes, I could... Is it being lowered again below £1 million? I thought I'd read that the government had said it was supposed to stay at £1 and be inflation linked from 2018. I rather assumed that since all the pension administrators were providing so much information about the £1 million allowance, with no information about any other allowance, and also providing so much explanation of how the LTA worked, that they thought they knew what they were talking about... and I didn't realise there was going to be, or expected to be, an LTA change in the budget in March... – Michael Jan 28 '16 at 14:07
  • It's just rumor, but I've seen in the news that they are now discussing lowering it to £750k, or £800k, along with other things (changing the taxation of contributions, etc.) – davmp Jan 28 '16 at 14:14
  • It's the government, they can and will change any previous guidance or law whenever it suits them it seems. And it suits them quite well indeed to tax your retirement savings as if they were a government piggybank. – davmp Jul 26 '17 at 0:06
6

Note - this is a complicated topic. I've read the rules multiple times and I'm still not sure I understand them perfectly. So please take this with a pinch of salt and read the rules for yourself.

The time(s) at which a test is done against the LTA are known as a "Benefit Crystallization Event" (BCE). There are 13 of these (!) - they're numbered 1-9 with the addition of some extras numbered 5A-D.

However, the most important ones for those with defined contribution pensions are:

  • BCE 1 (applies when using drawdown)
  • BCE 4 (applies when you buy an annuity)
  • BCE 6 (applies when you take a lump sum)
  • BCE 5A and 5B (applies when you reach age 75)

Broadly, the idea is that a BCE occurs when you start taking money out of your pension, and when you reach age 75. Each time one happens, the amount you are taking out ("crystallizing") gets compared against the LTA and a certain percentage of your LTA gets designated as being used.

Crystallising doesn't necessarily mean you actually receive the money immediately, just that some of your money is switched into a mode where you can start receiving it in different ways.

The rules are designed to avoid double counting, so broadly anything that was taken off your LTA won't be taken off a second time.

The cumulative use of your LTA is tracked as a percentage rather than an absolute amount, to take account of any changes in the LTA between the different times you crystallise money. For example if you crystallise £100K when the LTA is £1mn, that's 10% of your LTA gone. If later on the LTA has risen to £1.1mn and you take out £110K, that's another 10%. Once you hit 100%, you start paying a LTA charge on any excess.

Taking an annuity

The really simple path here is if you just get an annuity with your entire pot, before hitting age 75 (and you don't make any further pension contributions after).

Then only BCE 4 applies: your pension pot, all of which is being used to buy the annuity, is compared with the LTA.

After this point your entire pension pot is considered to be crystallized, so no more BCEs will apply - the tests at age 75 only apply if you still have money that you haven't taken out or used to buy an annuity.

The annuity payments themselves will be subject to income tax at your normal rate at the time you receive them, i.e. 0%, 20%, 40% or 45% depending on how much other income you have.

Adding a lump sum

In reality most people would want to take 25% of their pot as a lump sum at the same time as buying an annuity, given that it's tax-free if you're under the LTA.

At this point BCE 6 applies in addition to BCE 4, but again the overall effect of the test is pretty simple, look at the total pension pot (lump sum + cost of annuity), and if it's under the LTA you're fine.

Again, at this point no more BCEs will apply as all the money is considered to have been fully distributed.

If you only use part of the money for an annuity/lump sum, then only that part of the money is compared against the LTA, and the rest stays in your pension and will be compared later. The 25% limit for a tax-free lump sum applies to the total you are taking out at that point: if you have £200K and are taking out £100K, you can take out £25K as a tax-free lump sum and use £75K for the annuity. The other £100K stays in your pension.

Drawdown

Many people see annuity rates as very low and will want to take on more risk (and reward) by using "Drawdown" for at least part of their pension.

Essentially, you can designate part of your pension for drawdown, and at that point BCE 1 applies to the money you designate. Once designated, you can start drawing the money out as income, which will be taxed at your normal income tax rate at the time you receive it.

Again, you can take 25% as a lump sum at this point which will be subject to BCE 6. There's also an alternative route where you put everything into "flexi-access drawdown" without taking any lump sum immediately, and then as you actually withdraw income, 25% is tax-free and the rest is taxed as income. The overall effect is the same, but it gives you more control over when you get the tax-free bit.

However, because with drawdown you can actually leave the money in your pension and growing tax-free, there's a further test against the LTA at age 75 under BCE 5A. To avoid double-counting ("prevention of overlap"), the amount left in the drawdown fund at that point is reduced by whatever was previously tested against BCE 1. So if you put £150K into drawdown initially, and it's grown to £200K by age 75, then another £50K will crystallise under BCE 5A. I think that if you put £150K into drawdown initially and it grows by £50K, but you take that out as income so that only £150K (or less) remains at age 75, then the amount crystallising under BCE 5A is nil.

Also, when money is in drawdown, you can choose to use it to buy an annuity. BCE 4 is applied at this point (if before age 75), but as with BCE 5A, this is reduced by anything that was previously crystallised under BCE 1. If you only use some of it to buy an annuity, the reduction is pro-rataed, e.g. if you started out with £150K moved into drawdown, and later it has grown to £200K and you use £100K to buy an annuity, then the reduction is £75K so £25K is considered to have crystallised under BCE 4.

Reaching age 75

Once you reach age 75, as well as any money that's still in drawdown, anything you haven't yet crystallised at all gets tested against the LTA under BCE 5B.

If you go over the LTA

Broadly, once you go over the LTA, the charges are simple:

  • for lump sums, you pay 55% at the BCE and then no further tax
  • for anything else, like annuity purchase or flexible drawdown, you pay 25% and then income tax as money is actually received.

There's never any explanation given for these two rates, but I think it's all based on trying to at least cancel out the benefit you got from using your pension, on the assumption that:

  • you saved 40% income tax when you put in the money
  • you would pay 20% or 40% income tax if you take it out as income

So with the 25% charge + 20% income tax, if you take out £100, you'll end up with £75 gross income, so £60 net income - just the same as if you'd originally paid 40% tax. (This ignores the effect of investment growth, but if you would have saved the £60 in an ISA, the end result is the same: if you had growth of say 50% over the time the money was in your pension, it'll be the same effect if you had £100 growing to £150 and now received 60% of it, or if you had £60 growing to £90 untaxed in an ISA.)

The 55% lump sum charge is in case you are paying 40% tax when you take it out, to make sure that it's not a more attractive option than the 25%+income tax: if you have £100, either you get £45 tax free via a lump sum, or you get £75 gross and hence £45 net.

Other complications

I haven't covered lots of cases here:

  • defined benefit pensions. Roughly, when you start receiving the pension, 20x the initial income from the pension is deemed to crystallise under BCE 2 and any lump sum you receive crystallises under BCE 6. In the former case, you could end up having to pay the LTA charge with money you haven't actually got yet, and you can ask the pension administrator to instead reduce your pension to pay it. However, there are lots of special cases for defined benefit pensions, mostly for historical reasons, so you should make sure you check with your pension administrator about this.

  • if you die before age 75, at which point the LTA test is applied via either BCE 5C/5D, or BCE 7. After paying the LTA charge if any, your dependents or whoever else you leave it to gets the remainder tax-free.

  • transferring overseas (BCE 8).

  • "scheme pensions" under BCE 2 and BCE 3 (I think these are relatively uncommon)

  • some corner cases covered by regulations (BCE 9)

3

Rather than reading news stories, why not go straight to the HMRC source? https://www.gov.uk/tax-on-your-private-pension/lifetime-allowance

Seems your lifetime allowance measurement differs based on whether your pension is defined contribution or defined benefit. The latter seems fairly simple at 20 times first year payout, though the HMRC usage of the word "usually" is disconcerting.

The language for defined contribution implies they check multiple times for violation of the LFA, just like you've pointed out. Of note, they specifically list:

  • when you decide to withdraw money
  • when you turn 75
  • if you transfer your pension overseas

Note that you can also file to "protect" a larger LFA that you might have previously had. This generally means not contributing any longer to your pension though. There is info on the page linked above.

You must log in to answer this question.

Not the answer you're looking for? Browse other questions tagged .