Could you explain the lifetime allowance charge and whether it makes sense to take your excess as a lump sum or income?

Arthur

Tom Selby, AJ Bell Head of Retirement Policy says:

The lifetime allowance restricts how much you can draw in total from all your pensions over your lifetime before incurring a tax charge. The current lifetime allowance is £1,073,100.

Various ‘protections’ exist to allow savers to retain a higher lifetime allowance, subject to certain conditions being met.

The amount of lifetime allowance you have used will be tested whenever a ‘benefit crystallisation event’ occurs, such as taking your pension tax-free cash, taking an income via drawdown or buying an annuity.

A final lifetime allowanc test will be carried out at age 75, covering your ‘uncrystallised’ funds as well as any investment growth above withdrawals on your ‘crystallised’ funds.

If you have used up your available lifetime allowance, any excess will be subject to a lifetime allowance charge. The amount depends on whether you use the excess to provide an income or take it as a lump sum.

If you use the excess to provide an income, you will pay a 25% lifetime allowance charge, with any subsequent withdrawals taxed in the same way as income.

If you take the excess as a lump sum, you will pay a 55% lifetime allowance charge, with no income tax to pay.

The impact of taking the excess as an income versus lump sum will depend on the income tax bracket when the money is eventually withdrawn, and on how long it is left invested.

Let’s assume the excess is £50,000, meaning if someone took this as a lump sum the lifetime allowance charge would be £27,500 (£50,000 x 55%).

If they took the excess as an income instead, they would pay an initial charge of £12,500 (£50,000 x 25%). The remaining £37,500 would then be subject to income tax. 

For a basic-rate (20%) taxpayer, the income tax charge would be £7,500 (£37,500 x 20%), so a total of £20,000. A higher-rate (40%) taxpayer would be charged £15,000 (£37,500 x 40%), so a total of £27,500. An additional-rate (45%) taxpayer would incur a £16,875 (£37,500 x 45%) tax charge, so a total of £29,375.

Only the additional-rate taxpayer would be better off taking the lump sum. In practice, those with an excess may not need to take the money immediately.

The other consideration is inheritance tax. Taking the excess as a lump sum means it will be included in your estate for IHT purposes on death.

If left in the pension, it usually won’t be included in your estate and can be passed on tax-free to your nominated beneficiaries if you die before age 75. If you die after age 75, it will be taxed as income for your beneficiaries when they make a withdrawal.

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Please note, we only provide information and we do not
provide financial advice. If you’re unsure please consult a suitably qualified financial adviser. We cannot comment on individual investment portfolios.

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