Drawdown and the second lifetime allowance test

There are situations when a second lifetime allowance test takes place

November 2020

John Begg

Senior Compliance Consultant, ATEB Consulting

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Risk Disclaimer

The information, opinions, estimates or forecasts contained in this article were obtained from ATEB Consulting, are reasonably believed to be reliable and are subject to change at any time.

This content is directed only to persons having professional experience in matters relating to personal investment (investment professionals) and should not be distributed to anybody else. It has been prepared for general information purposes only. It does not constitute advice (whether investment, legal, regulatory, tax or otherwise) provided by BMO Global Asset Management (EMEA) (BMO). Tax treatment is based upon individual circumstances. BMO gives no warranty or representation, whether express or implied, that such content is up to date, complete, or accurate.

Investment professionals in receipt of this document should not rely on any of its content. They remain solely responsible for advising their underlying clients in accordance with their own legal and/or regulatory obligations and for taking their own independent advice as they determine is necessary.

To the extent lawful, BMO excludes all responsibility and associated liability for any loss or damage suffered by any recipient of this document who chooses to rely on its content, whether occurring in contract, tort (including negligence), breach of statutory duty, or otherwise, even if foreseeable.

Key takeaways:

  • Explain when the lifetime allowance is tested
  • Identify the situations when a second lifetime allowance test takes place
  • Be able to calculate the lifetime allowance
Background

The Lifetime Allowance (LTA) is the limit below which a person can crystallise benefits from their pension, without being subject to pay a LTA tax charge. Whilst there is no limit on the amount of pension benefits that a person can build up, a LTA tax charge applies when the LTA limit is exceeded.

The current LTA threshold is £1,073,100 and increases every April by the rate of CPI up to September of the previous year.

The tax rate depends on whether the excess is paid as a lump sum – called a Lifetime allowance excess lump sum and charged at 55% – or if retained to pay pension benefits, charged at 25% (tax is then payable on the income the member receives at their marginal rates).

When is the LTA tested?

There are several ways in which the LTA is tested, and this happens at the point of crystallisation, known as a Benefit Crystallisation Event (BCE). A full list of the different BCEs can be found here.

For drawdown, the tests that typically take place are as follows:

  • BCE 1
    Where funds are designated to provide a member with a drawdown pension;
  • BCE 6
    Where the member takes a relevant lump sum.

Therefore, every time funds are designated into drawdown, a LTA test takes place.

The Second Lifetime Allowance Test

However, there are situations where benefits are tested for a second time. For example, when a person designates funds to drawdown, a BCE occurs as outlined above, but, on reaching age 75, a second LTA test takes place.

This means that an individual who is crystallising benefits as a result of investment growth could be subject to a LTA tax charge on the basis of the second test. This second test essentially tests the growth in the fund value since the original funds were designated into drawdown.

The calculation for the second LTA test is as follows:

(Value at age 75 less the amount initially designated into drawdown) x 100 / LTA at the time of the second test = LTA used for tax purposes

For the purposes of the examples below, we have used the ‘shorthand’ version of the LTA calculation, based on percentages and this should produce an approximately correct LTA result. The technically ‘correct’ method for calculating LTA usage described in the legislation requires the past crystallised amount to be indexed at the same rate the standard LTA has been indexed. Where the shorthand method produces a different result, this is due to rounding down of percentages and the result should not be hugely different.

Example 1
  • Sam has pension benefits totalling £1m and in October 2016 and crystallises funds of £800,000 when the LTA was £1m, taking £200,000 TFC (BCE 6) and designating £600,000 into drawdown (BCE 1)
  • This uses 80% of his LTA i.e. £800,000 / £1m = 80%
  • No further funds are taken and in May 2020 he turns 75, with the £600,000 he originally placed into drawdown now worth £800,000•At age 75, the second drawdown test takes place:(£800,000 – £600,000 = £200,000) x 100 / £1,073,100 = 18.64%

    Sam’s remaining LTA would be 100% – 80% -18.64% = 1.36% of £1,073,100 or £14,594

    Sam has £200,000 of uncrystallised funds remaining and would be subject to a LTA charge on £185,406 (i.e. £200,000 – £14,594) at 25%

    The LTA tax charge is £46,351

Implications of the second drawdown test

We have seen a few instances where firms recommended crystallising 99% or 100% of the LTA in order to try and mitigate a LTA charge in the future. Firms should be careful when employing this strategy if the sole driver is to mitigate a LTA tax charge, as crystallising 100% of the LTA would mean that no benefit is gained from increases in line with CPI inflation, and the person could still be caught out by the second drawdown test. An example is shown below:

Example 2
  • James has pension benefits totalling £1m and in October 2016 crystallises the full fund when the LTA was £1m, taking £250,000 TFC (BCE 6) and designating £750,000 into drawdown (BCE 1)
  • This uses 100% of his LTA i.e. £1m / £1m = 100%
  • No further funds are taken and in May 2020 he turns 75, with the £750,000 he originally placed into drawdown now worth £950,000
  • At age 75, the second drawdown test takes place, but as there is no remaining LTA, the full £200,000 growth (i.e. £950,000 – £750,000) is subject to a LTA charge at 25%
  • He would therefore be subject to a LTA charge on £200,000 at 25%
  • HMRC will deduct £50,000 from James’s pension

In example 2, the adviser had tried to reduce James’s LTA charge by crystallising 100% of his LTA in October 2016. However, this had the opposite effect, as the client did not have any remaining LTA to benefit from the increases in line with CPI.

Risk Disclaimer

The information, opinions, estimates or forecasts contained in this article were obtained from ATEB Consulting, are reasonably believed to be reliable and are subject to change at any time.

This content is directed only to persons having professional experience in matters relating to personal investment (investment professionals) and should not be distributed to anybody else. It has been prepared for general information purposes only. It does not constitute advice (whether investment, legal, regulatory, tax or otherwise) provided by BMO Global Asset Management (EMEA) (BMO). Tax treatment is based upon individual circumstances. BMO gives no warranty or representation, whether express or implied, that such content is up to date, complete, or accurate.

Investment professionals in receipt of this document should not rely on any of its content. They remain solely responsible for advising their underlying clients in accordance with their own legal and/or regulatory obligations and for taking their own independent advice as they determine is necessary.

To the extent lawful, BMO excludes all responsibility and associated liability for any loss or damage suffered by any recipient of this document who chooses to rely on its content, whether occurring in contract, tort (including negligence), breach of statutory duty, or otherwise, even if foreseeable.

Our view

Firm’s should be aware of the challenges facing clients with potential LTA issues, and should take into account the client’s full financial circumstances, including whether they have any transitional protections, before embarking upon a relevant LTA strategy.

We suggest that great care is taken before advisers deliberately embark upon a course of crystallising 100% of client benefits, in an attempt to mitigate future LTA liabilities.

ATEB Consulting is a trading name of ATEB Business Solutions Limited Registered in England & Wales Reg. No: 5075208. Registered office: Evolve Business Centre, Cygnet Way, Houghton-le-Spring, County Durham, DH4 5QY.