RP case studies: Lifetime allowance versus income tax charges

In the latest RP case study, Fiona Tait looks at a SIPP saver in an enviable position. She explores the best options available as the client faces the LTA tax charge in two years' time...

Eric is a lucky man. He has an uncrystallised self-invested personal pension (SIPP) plan currently worth £691,184, as well as a scheme pension and an annuity in payment which together with the state pension are sufficient to meet his living expenses.

Everything in the pensions garden would, therefore, appear to be rosy, but there is a little worm in the bloom called the lifetime allowance (LTA) tax charge which Eric is going to be facing in two years’ time when he reaches age 75.  The SIPP plan was worth £316,000 in 2008 and it is now worth £691,000, which is over 100% increase in value. Many would consider it a nice problem to have.

Following our advice, he applied for Fixed Protection in 2012 and so has a personal LTA of £1.8m, however, 64% has already been used up by the benefits in payment. He has been reluctant to withdraw any further money and so he still has 36% of his personal LTA, £650,000, available. Under his income plan he is now due to withdraw a further tax-free lump sum, however, withdrawing more than he actually needs could potentially mitigate the LTA tax charge.

We explore three options:

  • Withdraw the amount he wants, and accept the LTA tax charge on the remainder at age 75.
  • Crystallise £650,000 (the remaining protected amount) and leave the remainder to face an LTA tax charge at 75
  • Crystallise £650,000 now, leave the remainder to face an LTA tax charge at 75, and withdraw income from the crystallised pot

Option 1 – Withdraw the amount he wants

Eric does not need any further income at this time, but he is looking to take £50,000 in PCLS. This would require a benefit crystallisation event (BCE) of £200,000 which would use up a further 11% of his personal LTA.

On this basis, there would be no LTA tax charge now, but in two years’ time we estimate his uncrystallised fund will be worth £555,000. This would be tested under BCE 5B, and he would also be subject to a charge on the growth of his funds within drawdown under BCE 5A. The client has no intention to withdraw the excess as a lump sum and therefore the applicable rate at 75 would be 25%.

Assuming an expected real growth rate of 3.1% p.a., which is in line with his investment portfolio, we estimate that the tax charge will apply as follows:

Projected fund subject to BCE 5A £  20,000
Projected fund subject to BCE 5B £555,000
Total tested against LTA £575,000
Available LTA £450,000
Excess over LTA £125,000
Tax charge @25% £  31,250

 

Option 2 – crystallise £650,000

Eric can crystallise £650,000 of his fund now without facing an LTA tax charge. Under this option, the projected uncrystallised pot at age 75 would be £47,000 and the growth on the crystallised fund would be £50,000.

Using the same assumptions as above the estimated LTA tax charge would be reduced to £24,000 and he would receive an immediate tax-free lump sum of £162,500. This would, of course, be included in his estate for inheritance tax (IHT) purposes but Eric is happy to accept this on the basis that he is in good health and can make plans to gift some of it away over the next few years.

Option 3 – crystallise £650,000 now and withdraw income from the crystallised pot

Withdrawing income would reduce the fund tested against BCE 5A at age 75, however it would also mean that Eric would pay income tax on income which he doesn’t actually need.

His current income made up of his state pension, scheme pension and annuity is £73,500 which is clearly above the higher rate tax threshold. The next threshold we need to consider is £100,000 at which point Eric would start to lose his personal allowance, which results in an effective tax rate of 60% on income between £100,000 and £123,000. We, therefore, suggest he withdraws £26,500 to stay below this limit.

Under this option, the amount tested against BCE 5A would be reduced to £20,000 and his total tax charge would be only £16,625.

Summary

Option Objective Projected LTA charge
Crystallise £200,000 Release £50,000 PCLS £32,000
Crystallise £650,000 Utilise available LTA £24,000
Crystallise £650,000 and withdraw income Utilise available LTA and reduce amount tested against BCE 5A £16,625

 

Based on these figures it is recommended that Eric crystallises the maximum amount within his remaining LTA. It is also recommended that he withdraws income of £26,500 per annum in order to reduce his LTA tax charge at age 75 while retaining his full personal allowance for income tax.

Fiona Tait is technical director at Intelligent Pensions