The reduction in the lifetime allowance and the fact more pension scheme members are choosing drawdown mean understanding and planning for the second LTA test is ever more relevant, writes Bernadette Lewis.
Understanding and planning for the second lifetime allowance (LTA) test is becoming ever more relevant. For one thing, pension freedom means more pension scheme members are choosing drawdown. For another, the LTA is now just £1m.
The first LTA test applies when someone takes their pension benefits via drawdown. Benefit crystallisation event (BCE) 6 covers tax free cash, and BCE 1 covers the drawdown amount – both using up a percentage of the available LTA.
If there is enough LTA to cover both BCEs, there is no LTA charge. Otherwise, the charge is 55% if the member takes the excess as a lump sum, or 25% if they use it for drawdown because they also pay income tax on any drawdown income.
The second LTA test applies when the drawdown member reaches age 75 or uses their funds to buy an annuity before then. It tests any increase in the value of their drawdown fund since BCE 1, ignoring the tax-free cash.
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.
Pre A-day drawdown is not subject to the second LTA test. If someone only has pre A-day drawdown, they will never be subject to an LTA charge. If they have pre and post A-day drawdown, the pre A-day plan is taken into account at their first post A-day BCE, and is not considered again for the second LTA test.
There is also an LTA test if someone reaches age 75 with uncrystallised funds in a money purchase arrangement. They keep the right to receive up to 25% of their remaining available LTA as tax-free cash. There is no option to take the excess over the LTA as a lump sum at the age 75 BCEs.
| Example
Steve crystallised £1.4m in October 2009 at age 67. He took £350,000 tax-free cash and moved £1.05m into drawdown, using 80% of the then £1.75m LTA. In October 2017, Steve is still in drawdown, facing a second LTA test at age 75. He has taken no income and his fund has grown by £390,000 to £1.44m. His remaining available LTA is 20% of £1m, or £200,000. The £190,000 excess is subject to a 25% LTA charge. The scheme administrator pays this to HMRC, leaving the balance in drawdown. |
These rules encourage drawdown members to take income. Taking withdrawals of at least the equivalent of any growth means there will be no increase in value – and no LTA charge at age 75.
| Example
Louise crystallised funds worth £1.5m at age 65 in October 2007. She took £375,000 tax-free cash and moved £1.125m into drawdown, using 93.75% of the then £1.6m LTA. In October 2017, Louise is subject to a second LTA test at age 75. She has been taking drawdown income of around 4% a year – a little less than her investment gains. Her fund is now worth £1.18m. The growth on her drawdown fund is £1.18m minus £1.125m = £55,000, using a further 5.5% of the current LTA. As this is less than her 6.25% available LTA, there is no LTA charge. |
As there are no limits on drawdown income, a charge at the second LTA test is largely optional. Where a drawdown member’s total funds are likely to exceed the LTA, they can either take withdrawals subject to income tax, or face the 25% LTA charge at age 75 plus income tax on later withdrawals.
The former is usually more favourable. As withdrawing a large lump sum just before age 75 could trigger high rates of income tax, the key is to take income over the years in as tax-efficient a way as possible. Inheritance tax (IHT) planning considerations may, however, mean paying any charge at age 75 is preferable to taking income.
If someone dies under age 75, any uncrystallised benefits paid as a lump sum or beneficiary drawdown are subject to an LTA test – then paid tax-free to beneficiaries. There is, however, no second LTA test on death for funds already in drawdown. In addition, there is no further test on death for any funds remaining in drawdown after age 75.
Wealthy people are increasingly using pension death benefits for estate planning following the pension freedom reforms. They cannot avoid the age 75 LTA test and face a 25% charge on any excess. Keeping funds invested in a tax-efficient pension outside their estate could, however, be preferable if they do not need income and their estate exceeds the IHT nil rate band.
On death, they are free to pass any remaining funds onto whoever they choose. The beneficiaries will pay income tax at their own rates whenever they take the funds. The alternative might mean taking withdrawals subject to both higher or additional rate tax and IHT if the funds are not spent or gifted.
Bernadette Lewis is a financial planning manager at Scottish Widows
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