As a result of the pension freedoms, more clients are likely to be in drawdown at age 75 and beyond. However, this means a lesser-known tax aspect is going to start having an impact on more people.
The snappily titled Benefit Crystallisation Event 5A comes into play for those still in drawdown at age 75. It measures the growth in the drawdown pot since the member originally entered it. If people take a higher income or get poor investment returns, that growth may be a minimal amount or zero.
However, for those taking little or no income who get a decent investment return, it can be a sizeable amount.
If the client has plenty of lifetime allowance remaining, it may not be a concern. But if people have previously used up most or all their lifetime allowance it could leave them facing a hefty tax charge.
Let’s look at an example. Max went into drawdown in 2007 when the lifetime allowance was £1.6m. He took £300,000 of his £1.2m pension pot as a tax-free lump sum, with the remaining £900,000 invested into drawdown. He used up 75 per cent of his lifetime allowance.
In 2017, Max reaches age 75. He has taken an income of £20,000 a year and achieved investment growth of around 5 per cent a year after charges. His drawdown plan at age 75 is valued at £1.25m. The growth in his pension pot to be measured against the lifetime allowance is £1.25m, less £900,000: £350,000.
Max has 25 per cent 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, which is 55 per cent if he takes the excess as a lump sum or an immediate 25 per cent if he leaves the excess in the pension wrapper. If he does this, he would also be liable for income tax on any further withdrawals.
For those approaching age 75, planning may help alleviate any tax charge. I have ignored any form of protection in this example but it may be an option for some people. Simply increasing withdrawals is an obvious route, as income tax on the withdrawal may be preferable to 55 per cent tax on any excess.
Altering investment strategy may be another option. Is there a need to take more risk when the majority of any growth will go to the tax man? And if passing on wealth is a key objective, accepting the 25 per cent tax charge to keep funds in the inheritance tax friendly pension may be the best option.
The lifetime allowance check at age 75 has largely been a theoretical concept in the past decade. But over the next few years more people may find it can have a damaging impact. Unless planning starts now.
Andrew Tully is pensions technical director at Retirement Advantage