The HMRC's lifetime allowance (LTA) limits the value of payments from your pension schemes – whether lump sums or retirement income – that can be made without triggering an extra tax charge. Many dentists will exceed the limit without realising it, especially following the reduction in LTA to £1.0m in April 2016.
This is a complex area of financial planning and one that requires a technical analysis of your pensions by an adviser who understands the specific issues involved. If your adviser or accountant has not discussed this with you, it is likely they don’t regularly advise on the topic. Here, I run through some of the aspects you should seek expert advice on.
What are the signs that you might be close to or already exceeding your LTA?
The key to understanding your proximity to the limit is valuing your existing pensions. With personal pensions this is the actual value. With NHS pensions this is 20x the income at retirement plus any tax-free cash lump sum.
Let’s look at a couple of examples:
- NHS pension only
You are predicted to get an NHS pension of £50,000pa at age 60 and a tax-free lump sum of £135,000. The LTA value of this is £50,000 x 20 + £150,000 = £1,150,000. You will exceed the LTA by £150,000.
- NHS pension and personal pensions
You are predicated to get an NHS pension of £35,000 and you have personal pensions valued at £400,000. For your NHS pension the LTA value is £35,000 x 20 + £105,000 = £805,000. Your total LTA value is therefore £805,000 + £400,000 = £1,205,000. You will exceed the LTA by £205,000.
I consider later the tax charge that might be associated with the excess and what you can do about it.
When is the LTA excess charge applied?
It is important to remember that a test against the LTA (and any subsequent charge) takes place when you draw benefits from your pension. Valuing your pensions now may be helpful but it is more important to consider their predicted LTA value at retirement. This is where some expert advice is helpful, especially where you have ongoing NHS income.
The LTA test will usually be at normal retirement age for the NHS pension and, in the case of personal pensions, it is when you take income or tax-free cash from the pension(s). A test will also occur at age 75 if you haven’t yet drawn benefits from your pension or in the event of your death before 75 or if you transfer benefits overseas. The technical name for drawing pension assets is a benefit crystallisation event (BCE).
What if you exceed your LTA?
This will depend on the type of pension you have. In the case of NHS pensions a formula is applied to work out the charge. The charge is then applied in the form of an annual deduction from your pension – i.e. it comes off the gross NHS pension income. For example 1 above, this would be as follows:
£150,000 (excess) x 25%/20 = £1,875pa charge. Instead of receiving £50,000pa you would receive £48,125pa. NHS Pensions are required by HMRC to use this formula. This settles your LTA charge – i.e. the annual deduction means you don’t have any further LTA charge to pay in respect of your NHS pension.
In example 2 above, the nature of the charge depends on how you take pension benefits. Let’s assume you take your NHS pension first: This will use £805,000 of the available £1.0m allowance. You then decide to take some tax-free cash from your personal pension fund. Every £1 of tax-free cash you withdraw ‘crystallises’ £4 of LTA. You only have a remaining LTA of £195,000, so once you have taken £48,750 of tax-free cash you will be subject to a charge on cash or income drawn thereafter. You can choose to take the charge as follows:
1. Designate a lump sum withdrawal – the charge is 55%.
2. Designate it as income withdrawal – the charge is 25% + income tax on withdrawals.
This is where things can get complicated! Advice on designating as lump sum or income will depend on a number of factors, including, but not limited to:
- consideration of death benefits/inheritance tax
- the need for income
- your income tax position.
It is possible to defer an LTA test on your personal pensions until age 75. This can have a significant advantage with regard to death benefits. It also could allow for an inflation rate increase of the LTA to above the prevailing £1.0m, assuming the government doesn't reduce it (as it has been doing in recent years). Advice is often lacking on the mitigation of the LTA charge and timing of this – where an adviser doesn’t understand the above options.
Do you need protection?
So-called HMRC protection is available and may reduce your LTA charge significantly. This is dependent on a detailed analysis of your individual circumstances. Briefly, HMRC’s Individual Protection 2016 could protect a further £250,000 above the current £1.0m allowance. In practice, this would save you an LTA charge of £3,125 every year where applied to your NHS pension and (in example 2 above) a lump sum tax charge of £112,750 (55% x the £205,000 excess). HMRC protection will need to be in place before your take pension benefits i.e. you can’t apply retrospectively for protection and expect a refund of the LTA charge!
If you have pensions which you intend to draw on imminently, you should ensure you take advice before your trigger the LTA test. Anyone considering NHS retirement should do this well in advance of applying for pension benefits. Even if you are several years from retirement, HMRC protection may be suitable, especially where you have personal pensions and a growing NHS pension. Seek advice from a specialist who understands the NHS pension and is experienced in mitigating the LTA charge, rather than leaving the issues to escalate.
About the author
Jon Drysdale is an independent financial adviser for Chartered Financial Planners PFM Dental. For more information visit www.pfmdental.co.uk