LTA check at 75 likely to have bigger impact on clients

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The number of people still in drawdown at age 75 has historically been fairly low. Before the pension freedoms the majority of retirees bought an annuity. And few of those who did choose drawdown encountered any issues with the lifetime allowance given the sizeable lifetime allowances we have seen over the last decade, and the various protections which have been available. All of that means the second lifetime allowance check which needs to take place for drawdown customers at age 75 has largely been a theoretical exercise since it was introduced.

But it is likely to have a bigger impact on clients over the next decade as many more are likely to be in drawdown at age 75 and beyond. Especially when we add in that pensions are increasingly being used as a tax-efficient way to cascade wealth down the generations, which may mean larger pots at older ages, and the lifetime allowance has nearly halved in value since its peak.

So what is this second check all about and how may it affect clients? Benefit Crystallisation Event 5A measures the growth in the drawdown pot since the member originally entered drawdown. Any growth is measured against the customer’s remaining lifetime allowance, if any. Any excess is then subject to the lifetime allowance tax charge.

Those clients with sizeable pension savings, taking little or no drawdown income and getting a decent investment return are most at risk.

Let’s look at an example. James entered drawdown in 2007 when the lifetime allowance was £1.6m. He took 25% of his £1.2m pension pot as a tax-free lump sum and the remaining £900,000 was invested into drawdown. This used up 75% of his lifetime allowance.

In 2017 James reaches age 75 having taken an income of £20,000 a year and achieved investment growth of around 5% a year after charges. His drawdown plan at age 75 is valued at £1.25m. The growth in his pension pot – which is measured against the lifetime allowance – is £350,000 (that’s the value at age 75, £1.25m, less the amount originally invested in drawdown, £900,000).

James has 25% of his lifetime allowance still available. The lifetime allowance in 2017 is £1m which means he has £250,000 left. As the growth is £350,000 this means he exceeds his available lifetime allowance by £100,000. That excess is subject to the lifetime allowance tax charge of 25%. And if James withdraws the funds from his drawdown he will be liable to income tax on any further withdrawals. If we assume he pays income tax at 40% on the withdrawals, the effective tax charge on that excess is 55%.

Some simple planning may help alleviate any tax charge. I’ve ignored any form of protection in this example, but that may be an option for some people. Taking higher withdrawals in the run up to age 75 is an obvious route to minimise any lifetime allowance tax charge. Or altering investment strategy may be another option – is there a desire to take greater risk when much of any growth will go to the tax man?

Some of the newer retirement solutions may also be helpful to some clients. Hybrid products can hold an annuity as an asset of the drawdown. This obviously gives a guaranteed lifetime income, with the flexibility to reinvest any income which isn’t needed. But it may also minimise any tax charge in comparison to a traditional drawdown plan as the annuity asset declines in value as the client gets older and so the value at age 75 is lower than the initial purchase price. This may help offset any increase in the other drawdown assets.

The lifetime allowance check at age 75 has largely been a theoretical concept through the last decade, but over the next few years it is likely to affect more of the increasing numbers of people staying in drawdown for longer. It can have a damaging impact on some clients, but some simple tax planning can help – especially if planning starts well in advance of age 75.

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