Clients will want to make sure they have chosen the right strategy for lifetime allowance excess, particularly if the funds need to be passed on to beneficiaries on death
Billy-Ray is turning 65 and is looking into the options he has from his company defined benefit pension scheme. He is a widower and has a 40-year-old daughter who is a higher rate taxpayer. He has an existing health condition but fully expects to live into his eighties.
Inheritance tax will be an issue for Billy-Ray on death, even after factoring in inheriting his late wife’s nil rate band and residence nil rate band.
He needs £28,000 gross to meet his essential and discretionary spending per annum. His state pension provides £5,500 of this (it has been reduced from the “full” flat rate as he was contracted out in the DB scheme).
While the DB scheme meets his income needs, it only provides a dependant’s pension on death, so his daughter would not get anything.
The scheme retirement options included a transfer value of £1.2m. Billy-Ray is attracted to this as he is aware of the pension freedoms and the inheritability of the remaining pension money.
That said, he is aware he should engage a professional adviser to explore his options, especially as he has no lifetime allowance protection.
Option one: Look at alternatives to transferring
Billy-Ray meets with his adviser who is keen to first look at alternative ways, other than a pension transfer, of achieving his objective. As Billy-Ray is aiming to pass on death benefits to his daughter, a protection plan could potentially provide death benefits with less risk. Unfortunately, Billy-Ray’s health would prohibitively rate him for getting life cover. So this is not an option.
A partial transfer may be another option but this is dependent on the scheme rules. Unfortunately, this option is not available from Billy-Ray’s scheme.
Option two: Transfer the pension, use 100 per cent of the LTA and leave the rest for his daughter
Assuming the pension achieves 3 per cent growth net of charges, taking £250,000 pension commencement lump sum and placing £750,000 into drawdown will use up Billy-Ray’s LTA. The net growth will provide him with the £22,500 he needs each year.
As the £750,000 in drawdown is needed to provide Billy-Ray’s income, his adviser turns his focus to what he should do with his LTA excess of £200,000. Should he crystallise this now or leave it for his daughter to eventually inherit?
Assuming Billy-Ray dies at age 82, there would be £247,927 to pass on to his daughter. This factors in 3 per cent growth and an LTA tax charge of £67,196 at age 75. Of this, his daughter would net, assuming higher rate tax and withdrawals taken over several tax years, £148,756.
If Billy-Ray crystallises the funds now and pays the 25 per cent LTA excess instead, then only the growth in the value placed into drawdown (£150,000) would be tested at age 75, leading to a further £12,897 being paid to HM Revenue & Customs. This would reduce the net benefit for his daughter to £143,417 upon his death.
Option three: Transfer, crystallise and take the income
If Billy-Ray were to take the 3 per cent income from the £150,000 that has been placed into drawdown from the LTA excess, he will receive an annual income of £7,200 net of basic rate tax. This is then placed into an Isa achieving 3 per cent growth net of charges.
Upon his death, the daughter could extract the £150,000 from the drawdown pot at higher rate tax and net £90,000. The Isa would provide her with £104,185 after IHT is paid. A total of £194,185 would be passed to her from this part of Billy-Ray’s pension.
His daughter could also move the full £150,000 into nominees drawdown then extract it more tax efficiently later or leave it to her beneficiaries and she still has the £104,185 that she has inherited from the Isa post-IHT.
Option four: Put the income in a pension for the daughter
But what if Billy-Ray used his gift out of excess income exemptions to make a pension contribution for his daughter?
Billy-Ray has spare basic rate band, so if he takes out £11,300 per annum from the LTA excess drawdown, this would exhaust by the time he dies. If this is paid into a pension for the daughter, the effect of relief at source means the full £11,300 will go into a pension in her own right.
Assuming the same growth, her pension will be worth £262,963 in 17 years’ time, which she would be able to access. After taking 25 per cent tax free and paying higher rate tax on the remainder, that would mean she receives £184,074.
This seems less than the previous option but, as she is a higher rate taxpayer, she will be able to reclaim £2,260 per annum from the pension contributions that have been made each year – a total of £38,824, which has helped out on an annual basis.
Planning around LTA excesses can be a tricky conundrum as it relies on a multitude of assumptions and, if the pot is to be passed on, knowing the tax rate of any beneficiaries is crucial. Also knowing when the beneficiaries can access the money is important. Billy-Ray’s daughter will be able to access her pension from age 57 (as the minimum pension age is expected to increase to this age in 2028). But if access will be needed earlier, an alternative plan will be needed and more numbers will need to be crunched.
Mark Devlin is technical manager at Prudential