The real benefit for breaching the lifetime allowance comes if the client is looking for tax-efficient ways to pass funds to the next generation
The lifetime allowance is set to increase from April for the first time since 2010. Given the hatchet that has been taken to the LTA since then, this is a welcome change in direction.
The plan to increase the LTA in line with the consumer price index was announced in 2015 and confirmed by the Treasury in July this year (although at least one former pensions minister has expressed views it may yet be due for a trim once more come Budget time).
The reality is that more and more people are being caught by the LTA and, although any increase in its level is welcomed, the CPI linking will slow the growth of people being caught, rather than change the direction of travel.
So, if you know they are likely to breach the LTA, why would you encourage a client to continue to put money into a pension? Let’s look at the pros and cons.
Those who have LTA issues are likely to be at least higher rate taxpayers – maybe additional rate.
Assuming higher rate relief going into a pension, any personal contributions will benefit from 40 per cent relief. If a client has control of their company and pays an employer contribution instead of salary, they effectively get 40 per cent relief plus National Insurance savings on top.
Ad we all know that, once in the pension, they benefit from tax-free compound growth.
On the downside, once the LTA is breached, a client is going to pay a tax charge on the excess, plus income tax on any withdrawals they make.
If they take the excess as income, the LTA charge is 25 per cent and then income tax on the balance. For a higher rate taxpayer, this is an effective rate of tax of 55 per cent.
Of course, someone who may have been a higher rate taxpayer while paying in may only be a basic rate taxpayer at point of withdrawal, in which case the effective rate of tax is only 40 per cent.
If the client chooses to take the excess as a lump sum instead of income, then the charge is 55 per cent, so really only a viable option for higher or additional rate taxpayers.
If a client is likely to be a basic rate taxpayer in retirement, then 40 per cent tax relief going in and 40 per cent tax coming out with the benefit of tax-free growth in between is not a bad deal.
If the client is still a higher rate taxpayer then the 55 per cent tax rate on withdrawal looks high, but they need to weigh up the benefit of those tax-free compound returns versus taxes paid if invested elsewhere over the same period.
The real benefit may come if the client does not need the pension above the LTA but is instead looking at tax-efficient ways of passing funds to the next generation.
If the pension is untouched on death before 75 then the 25 per cent LTA charge will apply to the excess, and the balance can be paid tax-free to any nominated beneficiaries provided designated within two years.
Taking the more optimistic view that they live beyond age 75, then the 25 per cent LTA charge will be taken on their 75th birthday, with growth thereafter exempt from any further test. Income tax will be payable when their beneficiaries eventually withdraw the funds but this will be at the beneficiaries’ marginal rate, not the client’s.
By this stage of life, the client may well have grandchildren, as well as children, and potentially great-grandchildren. They can have any number of beneficiaries and passing funds on to non-taxpayers is especially efficient. Beneficiaries under the age of 18 would effectively have their funds managed by parents and could be used for school fees or the like.
Another option if the client does not need the excess funds personally is to take income and use it to fund pension contributions for their children. By the time the client reaches later life, their children could well be higher rate taxpayers, so withdrawals at an effective rate of tax of 40 per cent could be used to fund their pension contributions in a tax neutral way. Doing this moves funds from a scheme with an LTA excess to the next generation who may not have the luxury of the same issue.
Lisa Webster is technical resources consultant at AJ Bell