Neil MacGillivray: When an LTA charge is the lesser of two evils

Advisers should never base a decision on one form of tax but consider the impact of all taxes throughout a client's lifetime, says Neil MacGillivray as he works through an LTA/IHT example showing why

Rewriting the rules on retirement planning

Earlier this month it was revealed the amount received by HM Revenue & Customs in respect of the lifetime allowance (LTA) charge has almost trebled in just three years – from £40m in 2014/15 to £110m in 2016/17. Over the same period, the number of individuals who breached the allowance has more than doubled – from 1,020 to 2,410.

Given the reduction in the standard LTA from £1.5m to £1.25m in 2014/15 then to £1m in 2016/17, it does not take a rocket scientist to work out the reasoning behind this. Even with the standard LTA in 2018/19 increasing in line with CPI to £1.03m, the trend for an ever-increasing tax take will continue.

Should the risk of breaching the LTA and a possible tax charge of up to 55% stop individuals continuing to contribute to their personal pension, however? One should never base a decision on one form of tax but consider the impact of all taxes throughout an individual’s lifetime.

Inheritance tax (IHT) is becoming an increasing problem for many and may be the greater evil. Despite the introduction of the residence nil rate band, IHT receipts hit a record high of £5.2bn in 2017/18 and now impacts one in 10 families.

The benefits of tax relief on pension contributions, the low tax environment the pension fund can grow under, and that the pension fund should fall outside the IHT regime may be sufficient to absolve the LTA charge.

Let’s take a simple example, based on our understanding of current law and HM Revenue & Customs practice: Harry, on hitting 50 years of age, has been advised, even without making any further contributions to his pension, that he will easily breach the lifetime allowance when he plans to retire aged 65.

He has also built up substantial assets over the years and his estate will be liable to IHT. He is considering two options – the first is to continue to contribute £10,000 gross per year to his pension or, as a 40% taxpayer, save £6,000 net into an ISA. We will assume the growth rate on the assets invested to be at 5% a year.

If Harry opts for an ISA at age 65 his fund will be worth £129,471. He then stops making contributions at this point and dies 10 years later when the fund has grown to £210,895. After an IHT charge at 40%, he would leave a net amount of £126,537 for his beneficiaries.

If he decides to continue to contribute to his pension and chooses flexible drawdown at age 65, the portion of the pension funded after age 50 would be worth £215,699. On crystallising his pension he retains the benefits within the pension, ensuring the LTA charge at the reduced rate of 25% would apply, leaving a net amount of £161,774. Assuming no income is taken 10 years later, the funds in his pension would have grown to £263,513.

If Harry died the day before his 75th birthday, his beneficiaries would receive the full amount tax free, leaving 108% more than opting to save the net amount in the ISA.

Worst-case scenario

On the other hand, if Harry died on or after his 75th birthday, the growth on the drawdown fund at age 75 would suffer a 25% LTA charge and the benefits would be liable to income tax on the beneficiaries. Even in the worst-case scenario where the whole fund was taxed at the additional rate of 45%, the beneficiaries would still be fractionally better off by 3.5%.

That said, the opportunity to pay the benefits by instalments to try and minimise tax, say, to the basic rate of 20%, would lead to the beneficiaries receiving 50% more over time. So, by breaching the LTA, Harry’s beneficiaries are still better off than if he opted to go down the ISA route.

This is a very simple example but does emphasise the importance of considering all taxes and not to be influenced by one headline rate. Like so many things in life, the devil is in the detail.

Neil MacGillivray is head of technical support at James Hay