On 6 April 2016, the standard lifetime allowance will drop to £1m. This is a significant reduction from its 2011/12 heyday of £1.8m.
The reaction of many will be to cut back on contributions in order to avoid incurring a LTA charge (currently 55 per cent on lump sums and 25 per cent if the funds are used for drawdown). For some, that will be the end of the story.
For others, however, the change to the death benefits rules in April 2015 may prompt them to run a few scenarios to see if there is any scope for some clever tax planning. Here are a few thoughts.
For higher and additional rate tax payers, making contributions can make sense if they intend to leave funds to beneficiaries who are basic rate or non-taxpayers, such as grandchildren.
If the member dies before age 75, any funds in excess of the LTA will normally be taxed at 25 per cent when used to provide a beneficiary’s drawdown pension. Those funds can then be paid out tax-free.
Alternatively, if you wait two years after death there is no LTA test, but the income will be taxed at the recipient’s marginal rate when paid. For grandchildren with no other income, this means they could withdraw income each year up to their personal allowance tax-free.
If the member dies after age 75, the LTA test will already have happened at age 75, so the 25 per cent tax charge will have been deducted before the distribution of death benefits. If the income is later paid to non-taxpayers, though, there would be no further tax to pay.
However, this is not all without risk. We are living longer, so the chance of grandchildren being adults – and therefore taxpayers – continues to grow (of course on the flipside great-grandchildren may arrive). If beneficiaries are 40 per cent or 45 per cent tax payers, making contributions above the LTA becomes less attractive if they are already taking a 25 per cent LTA hit up front.
The table below shows the effective rate of tax depending on the age at death and the tax rate of the beneficiary receiving the pension income.
There is also a risk that HMRC will not look too kindly on individuals using pensions for succession planning – and we have seen other ‘loopholes’ closed in the past – so care should be taken to justify contributions as being purely for retirement purposes.
It’s also worth remembering that the tax position of beneficiaries may change, so those making contributions are gambling on whether beneficiaries will end up paying a higher rate of income tax than IHT.
As with a lot of tax planning, it is still very much a case of walking a tightrope.
Martin Jones is technical services consultant at AJ Bell