Freeze in the LTA

Contents 

• The Freeze in the Lifetime allowance and the planning impacts
• Further contributions or benefit accrual
• When to crystallise?
• Crystallising early – key points
• Leaving funds uncrystallised until required or age 75 – key points

The Freeze in the Lifetime allowance and the planning impacts

The Spring 2021 Budget saw the announcement that the Lifetime Allowance (LTA) will be frozen at £1,073,100 until 5 April 2026. The LTA was due to increase with CPI each year as it has done since 2018. 

The freeze will once again see many with substantial pension funds both reviewing the benefits of continuing to make further contributions and for those over the minimum retirement age, reconsidering whether they should crystalise sooner rather than later.

Further contributions or benefit accrual

For those in defined benefit schemes, even where the LTA charge will apply, continuing to remain in the scheme is likely to give a better outcome than opting out in most cases.  However, it will of course depend on the specifics of the scheme and whether the employer is willing to offer a cash alternative.  Even where a cash alternative is offered it must be compared with the value of any benefits being given up. 

For employees in defined contribution schemes then again, the first thing to determine is what, if any, cash alternative the employer is willing to offer instead of the employer pension contributions.  Many employers are now offering to provide a cash alternative to those who will be subject to the LTA and this may be more beneficial. A key consideration here will be the client’s marginal income tax rates now compared with the likely tax rates when benefits are taken.  If no cash alternative is available, then it will generally make sense to continue in the scheme and suffer the LTA charge on any excess. 

Making personal contributions that will probably be subject to an LTA charge can be more difficult to justify.  However, there may be situations where they can still be of benefit.  For example, if the client’s income is in the £100,000 to £125,140 range a pension contribution can receive an effective 60% rate of relief due to the restoration of some or all of the personal allowance.  This compares favourably to the maximum 55% LTA charge on any excess.   Comparing the tax relief on the contribution with the total tax expected to be paid on the benefits will be important as well as other considerations such as the IHT benefits of the pension.

In addition to the possibility of an LTA charge, some will also need to consider the impact of any annual allowance charges, either due to higher earnings or high pension inputs to their Defined Benefit scheme.  

When to crystallise?

For those over the minimum retirement age with large defined contribution funds near or in excess of the LTA, the decision regarding when to crystallise can be complex.  

Choosing to crystallise funds earlier can avoid or reduce the LTA charge and the LTA freeze may make this appear a more attractive option.  Leaving the funds uncrystallised will no longer offer the inflationary protection of the LTA or increases in the maximum tax-free cash available over the medium term.

However, there are a number of other important factors that also need to be considered, including the second LTA charge at age 75 or earlier annuity purchase.  In addition to any LTA charges, advisers must also consider the client’s income needs, their income tax position, and any inheritance tax consequences, along with wider estate planning objectives.

Crystallising early – key points

• The tax-free cash is removed from the tax-efficient wrapper of the pension fund and so, if invested, is potentially exposed to income tax and CGT. 
• The tax-free cash sum now falls into the client’s estate.  If there is no immediate need for this it is now exposed to a potential 40% tax on death, whereas it could have remained outside of the estate within the pension fund. The maximum tax-free cash is £268,275 with the standard LTA.  Taking this could result in additional IHT of £107,310. 
• Crystallising the funds early allows the client to control any LTA charge at the point of the second LTA test at age 75 or earlier annuity purchase.  However, this will require taking any growth on the drawdown fund as income withdrawals.  These will be subject to income tax at the client’s highest marginal rates in the tax year it is received. A key consideration will be if and when the client is likely to need any income from the funds and whether it can be taken at more preferable lower marginal rates of income tax at some point in the future. 
• If no income is taken then the crystallisation simply removes the tax free cash element from the calculation with the potential IHT downsides outlined above. Any growth on the funds in drawdown will still be subject to the second LTA test.
• Crystallised funds are not subject to a further LTA test on death before age 75.  This can provide an LTA advantage over leaving the funds uncrystallised.

Leaving funds uncrystallised until required or age 75 – key points

• No funds are removed from the tax efficient pension wrapper or brought into the estate unless they are needed.

• Clients may have the option to use other investments to fund any income shortfalls, particularly during the early years of their retirement to reduce the value of their estate. 
• If income is only taken when required then it is less likely to suffer higher rates of income tax.
• The funds can remain outside of the estate for IHT purposes. 
• If client’s have no need for the excess above the LTA, they can leave the funds in the pension, suffer the 25% LTA charge at age 75 and leave the funds to pass on to their beneficiaries on death free of IHT (although potentially subject to income tax on withdrawal).
• Advisers can of course monitor and review this strategy at any point.  If the client needs to access the tax-free cash and or income before age 75, they can decide at that point whether to crystallise all the fund or just take up to the LTA at the time. 
• The full value of the uncrystallised funds will be subject to an LTA test on death before age 75. 
• If funds haven’t been taken at age 75, the client will need to review the decision as to whether to take the tax-free cash entitlement.  Whilst this remains beyond 75, the funds all become subject to income tax on death.  Taking the tax-free cash, may however, mean it is subject to 40% IHT.

Freezing the LTA has made LTA charges more likely for those with significant benefits who continue to contribute or accrue benefits.  It has also removed an advantage of leaving funds uncrystallised.  However, this remains a complex area of planning and in each case advisers need to consider the client’s individual circumstances.