Drawdown planning and the Lifetime Allowance Tests

With more clients opting for drawdown and many choosing to partially designate or ‘drip feed’ their funds, keeping track of the lifetime allowance (LTA) becomes more important. The tradition options of defined benefit pensions or annuity purchase were usually far simpler, often just creating one set of benefit crystallisations events (BCEs) and if these were within the available LTA at the time there were no further considerations.

With drawdown planning, they are both the initial tests which occur whenever all or part of the funds are designated and the second tests which occur when the client reaches age 75 or decides to use their crystallised funds to purchase an annuity, if sooner. The LTA position on death should also be considered.

The initial tests

Each time funds are crystallised into drawdown there are two BCEs, BCE 1 covers the funds being made available for drawdown and BCE 6 covers the tax-free cash amount. The amounts taken and designated are tested against the LTA that applies at the time, or the client’s higher protected LTA if applicable. The amounts are expressed as a percentage of the LTA.

For example, a client had a defined contribution fund worth £600,000 in October 2017 when the LTA was £1m. They decided to crystallise £100,000 at that time:

BCE 1 of £75,000 would use up 7.5% (£75,000/£1m) of the LTA

BCE 6 of £25,000 would use up 2.5% (25,000/£1m) of the LTA

The total used would be 10%.

Now the LTA increases each year with CPI the numbers themselves are a little more complex, but the calculation works in the same way. For example, if by July 2020 the uncrystallised funds had increased in value to £550,000 and the client decides to crystallise another £100,000 the calculations are:

BCE 1 of £75,000 would use up 6.98% of the LTA (£75,000/£1,073,100) of the LTA

BCE 6 of £25,000 would use up 2.32% of the LTA (£25,000/£1,073,100) of the LTA

So the client has now used up a total of 19.3% (10% + 9.3%) of their lifetime allowance leaving 80.7% available for future crystallisations.

The percentage used remains constant regardless of the subsequent changes to the lifetime allowance. 

The LTA charge

Any excess is subject to the lifetime allowance charge.  This is 55% where the excess is paid as a lump sum or 25% where the excess is used to provide income, with the income subject to income tax as and when it is withdrawn.  The rates are broadly neutral for a higher rate taxpayer.  When the rates were set it was expected that most people with an excess would be higher rate taxpayers.  With the decreases in the LTA and the increases in the higher rate income threshold this is no longer always the case and the 25% income option has become more popular.  In addition, some clients are using their pensions for estate planning and so will opt to suffer the 25% LTA charge and leave the rest of the funds invested to pass to their beneficiaries.

The age 75 tests

At age 75 there are two potential tests for those planning with drawdown.  Firstly, any funds that remain uncrystallised are tested at this point (BCE 5C).  This is simply the value of any uncrystallised funds divided by the LTA at the time.

A slightly more complex second test also applies to any funds that are still held in drawdown (BCE5A).  This test looks at the increase in the value of the drawdown fund since it was first designated. 

For example, a client first designated funds into drawdown in July 2010 on their 65th birthday.  They took £360,000 of tax-free cash and moved £1,080,000 into drawdown.  The LTA at the time was £1.8m and so they used up 80%.

At the time of the second LTA test the funds in drawdown had grown to £1,380,000.  This is an increase of £300,000.   

The client has no LTA protection; therefore their remaining LTA is 20% of the current LTA, i.e. £1,073,100 x 20% = £214,620

The £300,000 increase is £85,380 more than the available LTA and so this subject to a 25% tax charge of £21,345.  This will be deducted from the drawdown fund by the provider.  There is no 55% lump sum option at this point.

As there are no longer any limits on the income the client can take in drawdown, there is the option to control how much is subject to the second LTA test at age 75.  Income levels can be increased to reduce the fund value; however, any income will of course be subject to income tax.  In addition, this may increase the value of the estate for IHT purposes if the income is not required.

A similar LTA test also applies where clients choose to use their drawdown funds to buy an annuity before age 75 (BCE 4) testing any increase in value between the time the funds were placed in drawdown and the annuity purchase.

Death benefits and the LTA charge. 

There are is no further LTA tests on death before age 75 on funds already in drawdown.  They can be passed onto beneficiaries free of all taxes.  Any uncrystallised funds are subject to an LTA test on death.  Where there is an LTA charge, where it is available the 25% LTA charge on income is far more favourable than the 55% lump sum option. This is because the funds can be placed into beneficiary’s drawdown and then all taken immediately free of further tax if required.

As all benefits are tested or re-tested at age 75 there are no further LTA tests on death benefits post 75.