There are many benefits of retaining the excess in a pension over taking it as a lump sum
Last month, I looked at the two options available where an individual crystallised funds beyond their lifetime allowance prior to their 75th birthday.
One option was to take an LTA excess lump sum, taxable at a rate of 55 per cent. Another was to retain the excess in a pension subject to a tax charge at a rate of 25 per cent.
I considered the slightly different tax treatments of each before briefly touching on inheritance tax. This is something I said I would revisit in a future article, so let us now look at the potential IHT implications.
Robert has just turned 70 and is an additional rate taxpayer who has now crystallised the excess of £200,000 over his LTA in his Sipp. His intention is to make gifts to his two adult children.
Unfortunately, in the two different scenarios in question – lump sum and drawdown – he dies shortly after crystallising the funds. He is a widower and his estate will be subject to IHT.
In the first scenario, he has not yet paid the total net amount of the lump sum to his son and daughter, and in the second, he has only paid each of them £10,000 from surplus income. Also under the second scenario, on the death of Robert, his children, as nominees, would have the option of taking either a tax-free lump sum death benefit or tax-free income from the beneficiary’s flexi-access drawdown funds.
As table 1 shows, although every case has its own individual merits, comparing the lifetime allowance excess lump sum scenario to the drawdown scenario would suggest very careful thought needs to be given to exercising the first.
I have come across a few suggestions that an individual might consider taking the lump sum option and investing the net proceeds in an Isa. Again, it is open to question as to whether this is an appropriate course of action as it does not alleviate the issue of possible IHT.
In a third scenario, Robert invests the excess lump sum in an Isa each year over a five-year period, then lives a further 10 years, while in the fourth scenario he retains the net fund in drawdown (see table 2).
No income or capital is taken either from the Isa or drawdown fund with annualised investment returns of 5 per cent for the Isa and pension, with 1 per cent for holding the balance of the lump sum in cash until investment in the Isa. The Isa subscription each year is £20,000, with a balance of £11,634 paid in the final year.
In the worst-case drawdown outcome, the beneficiaries take the excess drawdown fund in its entirety as an income payment and pay tax on the whole amount at 45 per cent. However, they would still be 54.7 per cent better off than having inherited the Isa monies.
If, over time, the beneficiaries were able to extract income from the drawdown funds at 20 per cent, then the net fund after all taxes would be equivalent to £235,968 (assuming no further growth) or £131,145 more than was left from the Isa.
The next obvious question to ask is what the outcome would be if Robert never crystallised the £200,000 at all. Well, assuming the same returns etc, at age 75 the fund would be worth £255,256 with an LTA charge of £63,814. Ten years later, the remaining £191,442 would have grown to £311,838.
If Robert had grandchildren or great-grandchildren who were non-taxpayers and who were nominees, then an amount up to their personal allowance could be withdrawn each year from their “inherited” pension pots without any tax to pay. This equates to 197 per cent more than what would be available under the Isa route.
It is this ability to pass on death benefits from a pension in a tax-efficient manner that has opened up opportunities for advisers to add value and attract new clients as the money is cascaded down through the generations.
The caveat, as always when it comes to pension tax legislation, is that with opportunity comes complexity and trying to navigate the minefield of legislation can sometimes lead to unintended consequences.
Neil MacGillivray is head of technical support at James Hay