Lisa Webster: Should the lifetime allowance knowingly be exceeded?

Are there any reasons why an adviser should tell a client to continue contributing to their pension, knowing they are likely to hit the lifetime allowance (LTA) threshold? Lisa Webster evaluates

With estimates of more than a million people set to exceed the lifetime allowance LTA are there any reasons why you should advise a client to continue contributing to their pension in the knowledge they are likely to have an issue?

Let’s look at the arguments for and against.

On the ‘for’ side we know that those who have LTA issues are likely to be at least higher rate tax payers, quite possibly additional rate tax payers (or top rate if they are resident in Scotland). So let us assume any personal contributions to pensions will benefit from at least 40% relief.

In terms of employer contributions there’s even more benefit. If salary sacrifice is operated then there are national insurance savings to be had on top of this, and for employer contributions on top of salary this is effectively free money from the client’s point of view.

All positive stuff – of course assuming your client has annual allowance available.

Once the money is in the pension it will then benefit from tax-free compound growth.

On the downside, when your client comes to take benefits, reaches age 75 or dies earlier, and the LTA is breached there will be a tax charge to pay on the excess.

A critical part of the decision whether to continue funding will be what the effective rate of tax is when payments are eventually withdrawn from the pension.

We’re looking at the LTA excess only, so there’s no tax-free element. As a minimum there will always be the 25% LTA charge, whether this is at the point the member puts the funds into drawdown, they reach age 75, or die before age 75 and the funds are then used to provide a beneficiary with a pension.

What tax is payable above this is down to who is getting the money and if it’s not the original client, how old they were at death. If the client is taking income – are they likely to still be a higher rate tax payer (or worse) in retirement? Or will they be in a position to manage their income and keep it within the basic rate band. If funds are ultimately used to provide a beneficiary with income, what’s the tax position of the likely recipients?

Looking first at a client who is a higher rate tax payer in retirement. The effective rate of tax will be 55%, either as a combination of 25% LTA charge and 40% income tax on the balance, or a straight 55% tax charge on the lump sum option – which may be more attractive for any recipient who pays income tax at a rate of above 40%.

The 55% tax rate on withdrawal may sound high, but it needs weighing up against the benefit of the initial tax relief and those tax-free compound returns, versus taxes paid if invested elsewhere over the same period.

It’s also worth remembering that monies within the pension on death are outside the estate – again a likely consideration for those who remain higher rate tax payers in retirement. When weighing up further pension contributions bear in mind that most alternatives will potentially be liable to IHT.

If the client is a basic rate tax payer in retirement, the effective rate drops to 40% (25% LTA and 20% income tax on the balance). With 40% tax relief on the way in, or “free money” from your employer, and the benefit of compound tax-free growth up to the point of withdrawal, 40% tax on the way out shouldn’t be enough to warrant an automatic stop to contributions where annual allowance permits.

However the more relevant question for many with LTA issues will be – are you likely to use all of your pension in your lifetime? The answer will vary, but if there are other sources of income and/or reduced life expectancy then the answer may well be “unlikely”.

The client’s rate of tax in retirement then becomes less relevant, but instead the question is who is likely to be the ultimate recipient and what tax bracket are they likely to fall in to?

Where the excess isn’t needed by the member, it can be a tax-efficient way of passing funds to the next generation. By this stage of life there may well be grandchildren, as well as children, and potentially great-grandchildren. There is no limit on the number of beneficiaries, and passing funds on to non-taxpayers is especially efficient as they can use personal allowances to withdraw funds with no income tax, even where the client died after 75.

From a practical point of view beneficiaries under the age of 18 can have their funds managed by parents and withdrawals could be used for school fees or the like.

It won’t be right for every client, but projections that lead to the LTA being exceeded shouldn’t prompt an automatic stop to contributions. What is vital though is that the client understands that although they should have larger funds than under alternative methods of investment a tax charge is likely to apply.

Lisa Webster is senior technical consultant at AJ Bell