Lifetime Allowance for Pensions

[AsleepInYorkshire]

Have I understood this subject correctly please?

The LTA is an amount an individual can be paid through pensions over their lifetime before triggering additional tax's.

The LTA includes any lump sums paid out regardless of them being tax free or not.

What I'm struggling with is the LTA Protection issue. This seems to have reduced in recent years and is not aligned with any inflationary index that I can identify.

Would I be correct in assuming that I could [potentially] arrive at the other end with too large a pension pot?

I've got a lovely spreadsheet all working now. Taken me a few months to refine it. It allows me to punch in variables and see an outcome. Don't get me wrong I'm more than aware it's not a magic crystal ball I've invented. It's more a ball park guide to where I will end up dependant upon amount saved, annual returns and the period of investment. It also factors in draw down impact upon the crystallisation event and I can vary the draw down percentage. I have left this at 4% being the "advisory" maximum draw down. It also factors in state pensions and assumes tax will be paid at 20% on all income above personal allowances (noting the latter is far more complicated but I wanted the spreadsheet to guide my decisions now, not to become a work of art in assessing all things all the time). The spreadsheet also allows me to inflate the tax allowances and state pensions and I have set them all to 1% pa over the next 15 years. I have not bothered with costs of managing the funds as I can reduce the projected growth of the fund to include these.

But the question I have asked myself now is could I over commit to pension contributions at the expense of "living today" and or considering another savings vehicle such as an ISA.

I currently like the pension route as I have a head-start in that area already. Also my employer will contribute to my pension too. Under these circumstances I can contribute about £20K pa to my pension including employer contributions and tax rebates. If I go down the ISA route that figure will reduce quite significantly. I also think upon passing the pension (which is private) will pass to my good lady if she outlives me or my daughter if not. And that will be tax free until they draw down from it?

Again if I have understood all of the above correctly then I think I should consider maximising my pension contributions until I reach a "self sustaining" pension pot and then changing to an ISA or doing both from the outset now.

What I'd like to do is be able to live in the meantime (of course ).

Have I sort of got the correct grip on the outline or have I missed something super duper important?

Thank you in advance
AiY

[Alaric]

The LTA is an amount an individual can be paid through pensions over their lifetime before triggering additional tax's.

It would be easier to define it as the amount the total worth of all your pension schemes cannot exceed. If invested assets do exceptionally well, that takes the holder closer to breaching the limit. There are obviously additional rules as to how it works once you start taking money from the assets. In general if you take money out, it's taxed anyway so there's no double counting.

[AsleepInYorkshire]

The LTA is an amount an individual can be paid through pensions over their lifetime before triggering additional tax's.

It would be easier to define it as the amount the total worth of all your pension schemes cannot exceed. If invested assets do exceptionally well, that takes the holder closer to breaching the limit. There are obviously additional rules as to how it works once you start taking money from the assets. In general if you take money out, it's taxed anyway so there's no double counting.

Thank you for clarifying. Appreciated greatly. Yes. This is what I've read elsewhere on the boards and hence my search for clarity. It's a little confusing. Well at least for my incy wincey brain . I think a lot of this stuff is about familiarity and often I pick something up only to forget it as it basically amounts to "information overload"

I've put some "variables" into my spreadsheet.

Parameters

1. Annual Contribution 20K
2. Annual Growth 10%
3. Trigger Crystallisation 15 Years (when my good lady is 67)
4. 25% Tax Free Lump Sum Taken at Crystallisation
5. 4% Draw Down pa(after crystallisation)
6. Continued Annual Growth of Pension at 10% pa.

Ball Park Outcomes

1. Gross Pot at 15 years = 1,077K (noting the pot isn't starting from zero)
2. Tax Free Lump Sum = 269K
3. Pension pa 32.7K
4. Growth pa = 81K
5. Nett Pension Pot Increase = 48K pa.

Conclusion

1. I've not understood the process well enough and thus the numbers are rubbish
2. I can draw down more than 4% "if necessary" to keep the "fund" below the LTA?
3. I could consider lower contributions to the Pension Fund when it reaches a self sustaining point?
4. The assumed growth rate is excessive?

Where it gets even more confusing is what happens if [when] I pass away. Does the size of the pension fund get added to any private pension fund sums my good lady has? Her private pension is about 1/5th the size of mine. Noting she has a protected workplace pension which when added to her state pension will mean she retires on more than she will have been earning, without touching her private pension.

Finally and to try and put the above into context of "other incomes" the spreadsheet includes both state pensions, both private pensions in draw down and my good ladies workplace pension. That figure is (gross) £77K pa. Which does look excessive?

AiY

[Alaric]

I can draw down more than 4% "if necessary" to keep the "fund" below the LTA?
I could consider lower contributions to the Pension Fund when it reaches a self sustaining point?

Both of the above. It's about tax. If you take a drawdown, you pay Income Tax on it. The higher the contributions, the greater the Tax Relief.

If your investment choices do really well, you are more likely to run into a LTA problem.

If you have a million pound pension fund and earn 10% a year, you have potentially a life of wealth and plenty spending £ 100,000 a year. If you just get 1% you may struggle to make ends meet on £ 10,000 year.

[AsleepInYorkshire]

I can draw down more than 4% "if necessary" to keep the "fund" below the LTA?
I could consider lower contributions to the Pension Fund when it reaches a self sustaining point?

Both of the above. It's about tax. If you take a drawdown, you pay Income Tax on it. The higher the contributions, the greater the Tax Relief.

If your investment choices do really well, you are more likely to run into a LTA problem.

If you have a million pound pension fund and earn 10% a year, you have potentially a life of wealth and plenty spending £ 100,000 a year. If you just get 1% you may struggle to make ends meet on £ 10,000 year.

Many thanks, greatly appreciated indeed.

AiY

[ursaminortaur]

I can draw down more than 4% "if necessary" to keep the "fund" below the LTA?
I could consider lower contributions to the Pension Fund when it reaches a self sustaining point?

Both of the above. It's about tax. If you take a drawdown, you pay Income Tax on it. The higher the contributions, the greater the Tax Relief.

If your investment choices do really well, you are more likely to run into a LTA problem.

If you have a million pound pension fund and earn 10% a year, you have potentially a life of wealth and plenty spending £ 100,000 a year. If you just get 1% you may struggle to make ends meet on £ 10,000 year.

Many thanks, greatly appreciated indeed.

AiY

The LTA test is against the total value of all your pension pots added up.

If a pension pot is that of a defined contribution pension then this is just the value of the pot. If the pension is instead a defined benefit pension then the value of the pension used in the calculation is 20 x the annual pension paid + any tax free lump sum paid.
The LTA test is carried out when various events (known as Benefit crystallisation events - BCEs) occur. For the most part these occur when you start taking a pension ie you start taking a DB pension or use a DC pension to buy an annuity or have it crystallised and put into drawdown. Others occur on death, or at age 75 or if you move a pension abroad using a QROPS.
For further details see

https://www.aegon.co.uk/support/faq/pension-technical/Benefit-crystallisation-event3.html

Each time one of these events occurs, eg You take a DB pension, the calculated total value of that pension is tested against the LTA limit (or if you have already taken one or more pensions against whatever percentage is left of the LTA limit) and you are deemed to have used up a percentage of your LTA limit. If you exceed the LTA limit then the excess will attract a charge of 55% of the excess value.

Generally each pension pot just attracts one LTA test. The main exception to that is with drawdown.

There are two forms of drawdown

1) Flexible drawdown - with this a tax free lump sum of upto 25% of the pot is taken and the pot is put into drawdown. Money drawn out after the tax free lump sum has been taken is taxed at your marginal rate. In this case an LTA test is carried out when the fund is crystallised/put into drawdown. No subsequent LTA tests are carried out when you drawout money later however there is a further LTA test at age 75. This LTA test at age 75 just looks at the any growth that has occured since entering drawdown which is still in the pot at age 75 - hence you can avoid any increase in the amount of LTA used up by making sure you have drawn down any growth before reaching age 75. This is the only instance in which increasing the amount you drawdown can stop you breaching the LTA limit.


2) UFPLS - with this the DC pension is left uncrystallised but you drawdown amounts from the pension at regular or irregular intervals. 25% of that drawdown amount is considered a tax free lump sum and the other 75 percent is taxed at your marginal rate. In this instance an LTA test is conducted everytime you take a UFPLS drawdown amount from the pension and a further test is carried out on any left over uncrystallised funds still in the pot at age 75.

[JohnB]

With the OPs numbers, they need not worry. 10% growth is optimistic, and the LTA is inflation linked and will be a lot more than a million in 15 years. When modelling be clear whether you are including inflation or not. I prefer ignoring it so the numbers feel real, and have a lower growth rate.

[Wuffle]

If compromising current lifestyle is really a concern, to what extent would anyone consider the complications that real life can bring?
An inheritance, which is reasonably likely to chime in coincidental to the last few years of work could very easily write off years of tax if dumped into a private pension, given the right personal circumstances. Would anyone stop healthily short of the LTA under the right circumstances?
Can you end up contemplating weird stuff like arbitraging cheap loans to tax benefits towards the end of work?
Just wondering.

[JohnB]

With the OPs numbers, they need not worry. 10% growth is optimistic, and the LTA is inflation linked and will be a lot more than a million in 15 years. When modelling be clear whether you are including inflation or not. I prefer ignoring it so the numbers feel real, and have a lower growth rate.

[TUK020]

One way of thinking about pensions is that it is 'tax rate arbirtrage'

If you are a higher rate tax payer while earning, then contributions will get tax relief at higher rate. From the figures quoted you will be paying basic rate tax on receiving pension payments (after taking 25% tax free lump sum).

Any contributions to the pension scheme that take you below the higher rate tax band are considerably less attractive than the ones done at higher rate.

[Urbandreamer]

Have I understood this subject correctly please?
.....
Have I sort of got the correct grip on the outline or have I missed something super duper important?

Thank you in advance
AiY

I have a similar spreadsheet, and it can be disturbing. The only thing that I think you may have missed or misunderstood is that it really IS that complicated and horid a system.

I am not targeting a 10%pa, but a 3.5%pa return. However I am making significant contributions into my pension.

My intention is to retire early, but if that doesn't happen then I will hit the LTA if nothing changes. The difference working and contributing those 5-7 years make is stark.

To be clear the HUGE difference is between snowballing, currently at 10% (contributions + internal return) and 0% or negative growth, due to drawdown.

There may come a point at which it makes sense to reduce or abandon contributions into a pension and replace them with ISA contributions or possibly VCT investments.

[Degsy67]

10% return on investments is far too high in my opinion. If you assume that inflation is 0% in your model so that all numbers are in current terms then setting investment returns at 5% is a much more realistic level.

When considering pensions vs ISAs you also have to consider the date you can access funds as well as flexibility and tax treatment at the point of withdrawal to get the balance right. Consider the following:

a) You are 50 years old and have sufficient funds in your various pension pots to fund sustainable withdrawals until you are 100 years old. However, all of the money is locked away in pensions which you can’t access until you’re 55 so you have to keep working for 5 more years. If you had 5 years of funds in gilts sat in ISA accounts then you could retire today.

b) You’re 57 years old and happily living off your various pension pots, being very careful with how you withdraw funds to be tax efficient. You’re happy to pay a little tax at 20% but don’t want to breach the higher rate tax threshold. Suddenly all your plans go out of the window when your central heating breaks down and your car fails the MOT with a major fault in the same month that you are about to embark on the once in a lifetime around the world cruise you always promised yourself. If you had some of your retirement funds in an ISA then you can get access to them straight away with no tax implications for the current tax year.

Now I’m getting closer to financial independence myself, I have a growing appreciation for the flexibility of ISAs vs pensions. My own over complicated tax optimisation spreadsheet suggests that we will deplete funds in our ISA accounts relatively early in our drawdown phase. My gut feel tells me that I may need to trade off a little bit of tax optimisation for ISA withdrawal flexibility.

Degsy

[hiriskpaul]

If you exceed the LTA you actually have 2 choices. You can take the excess as a lump sum and pay a 55% charge. Alternatively you can pay a 25% charge and leave the rest invested in the pension fund. You then pay income tax on subsequent withdrawals in the normal way. For many if not most people, I suspect that the latter route is preferable. If the excess can be withdrawn at the basic rate, the charge+income tax on the excess works out at only 40% instead of 55%. e.g. 100k excess reduced to 75k after LTA charge, income tax at 20% of 75k is 15k, so after charge and tax, amount withdrawn is 60k.

Leaving the excess in the pension fund means it remains invested and enjoys all the pension fund benefits:

- tax free growth
- pension fund passed to beneficiaries free of inheritance tax
- beneficiaries gain access to entire fund free of income tax if death occurs before age 75

For anyone receiving an employer contribution and/or paying tax at 40% or more, it is likely to be beneficial to continue pension contributions and pay the LTA excess charge.

[AsleepInYorkshire]

10% return on investments is far too high in my opinion. If you assume that inflation is 0% in your model so that all numbers are in current terms then setting investment returns at 5% is a much more realistic level.

Yes I agree. My pension is invested in two pots albeit not equally. Over the last 10 years the smallest pot has grown by 15.7% per annum after costs. The larger pot has grown by 10.01% after costs. I was seeking clarity on [potential] issues regarding the LTA and in particular having almost got to a strategy for investment I wanted to make sure it didn't end in disaster at the other end for reasons I have not understood now. Neither of the funds I am invested in are considered to be high risk, albeit I am considering some slightly higher exposure to the larger fund which has grown the least over the last decade. I should also have mentioned what "we" need to live on. And that's about £2,000 per month running one vehicle only. So an income of around 77K per annum seems to cover any minor discrepancies. I'm only looking at this ball park as I have control over several factors.

1. When I retire or if I semi retire and wait for my good lady to do the same
2. How much I put into the pension. I can [significantly] increase this
3. Where I invest the "fund[s]

When considering pensions vs ISAs you also have to consider the date you can access funds as well as flexibility and tax treatment at the point of withdrawal to get the balance right. Consider the following: a) You are 50 years old and have sufficient funds in your various pension pots to fund sustainable withdrawals until you are 100 years old. However, all of the money is locked away in pensions which you can’t access until you’re 55 so you have to keep working for 5 more years. If you had 5 years of funds in gilts sat in ISA accounts then you could retire today.

I'm 57Regrettably and due to factors so far outside of my control I still struggle to comprehend them I have reached a stage in life where this is one element I do not have control of. I've had a prolonged and incorrectly diagnosed health issue. All sorted now ... only took four decades

b) You’re 57 years old and happily living off your various pension pots, being very careful with how you withdraw funds to be tax efficient. You’re happy to pay a little tax at 20% but don’t want to breach the higher rate tax threshold. Suddenly all your plans go out of the window when your central heating breaks down and your car fails the MOT with a major fault in the same month that you are about to embark on the once in a lifetime around the world cruise you always promised yourself. If you had some of your retirement funds in an ISA then you can get access to them straight away with no tax implications for the current tax year.

I'm 57. I wasn't correctly diagnosed and treated correctly until I was 54. Before which no amount of planning could ever prepare me (or my loved ones) for the fate my health had in store for me. I have, however, since then cleared the overdraft[s], paid for two new cars, ruined my 12 year old daughter, refurnished the lounge, dining room, three bedrooms and even managed a holiday to Tenerife. I have even managed to set aside the funds to pay my mortgage off - but they make £6pa to every £1 I spend on my mortgage. I also have 5 months full salary in cash in my current account and have paid for all of this years Xmas gifts. I know what financial disaster is - I have lived through it, simply because I was ill. You couldn't make it up But next time I'll be ready.

Now I’m getting closer to financial independence myself, I have a growing appreciation for the flexibility of ISAs vs pensions. My own over complicated tax optimisation spreadsheet suggests that we will deplete funds in our ISA accounts relatively early in our drawdown phase. My gut feel tells me that I may need to trade off a little bit of tax optimisation for ISA withdrawal flexibility

I hope your plans go well. It sounds as if you have worked hard to bring them to fruition.

AiY

[AsleepInYorkshire]

I have a similar spreadsheet, and it can be disturbing. The only thing that I think you may have missed or misunderstood is that it really IS that complicated and horrid a system.
I am not targeting a 10%pa, but a 3.5%pa return. However I am making significant contributions into my pension.

Oh hell. I'm not sure I can cope with the truth . Seriously though I did need to hear that it was complicated as I was genuinely concerned that I was over-thinking the entire subject. I will raise my game. I am interested in the figure you are quoting of 3.5%. I'm assuming based on previous comments you've made that this is 6% gross? If I recall correctly you quote 3.5% as being net of inflation? If I'm having memories I shouldn't please feel free to condemn me to the stocks (pun intended)

My intention is to retire early, but if that doesn't happen then I will hit the LTA if nothing changes. The difference working and contributing those 5-7 years make is stark.

Yup. My sad little spreadsheet says just the same. My small dilemma (after all the others) is my good lady will reach "retirement age" 6 years after me - by which time I could be (no let's not go there ) Also I see you have a "contingency "Plan B" built in which is what I hope my plan does, by "the spread".

To be clear the HUGE difference is between snowballing, currently at 10% (contributions + internal return) and 0% or negative growth, due to drawdown.

There may come a point at which it makes sense to reduce or abandon contributions into a pension and replace them with ISA contributions or possibly VCT investments.

My "commercial" guts are telling me this and you're confirming it. But I have no idea how to work that "end out" (out-turn). Thank you for your response, as usual it not only helps but also provides inspiration.

AiY

[Urbandreamer]

Oh hell. I'm not sure I can cope with the truth . Seriously though I did need to hear that it was complicated as I was genuinely concerned that I was over-thinking the entire subject. I will raise my game. I am interested in the figure you are quoting of 3.5%. I'm assuming based on previous comments you've made that this is 6% gross? If I recall correctly you quote 3.5% as being net of inflation? If I'm having memories I shouldn't please feel free to condemn me to the stocks (pun intended)

Well I think that you have probably understood my point. Of course you don't mention that you understand that it (state rules) WILL change at least twice in your timescale, if not simply every year!

Others have pointed out the importance of flexibility. From their point of view I had it easy. To retire early I HAD to avoid pensions. In our day you retired at 65 regardless of your desire and you couldn't get your pension before your employer decided so.

Hence much of my income when I retire early will come from ISA's (as I intended to give up work early) and while I continue to work my contributions can go entirely towards a regulated pension (being over 55).

The pension system back then didn't allow that as an option. It still doesn't in my opinion ,50 or 45 is out of the question regardless of what you earn, given the current system.

3.5% is a figure plucked out of the air, ignoring inflation. If we were to include inflation it would be 5-6%. It's quite conservative, but that is what I want from my spreadsheet. I personally think that you should base your growth rate upon your drawdown rate (or natural yield), though that may be because I have no intention of ever dropping dead.

The asumption of "natural yield" is that good companies ride inflation. If their returns were less than inflation they would, over time, cease to exist.

[Kantwebefriends]

You should distinguish two issues: (a) saving and investing enough money to support you in retirement, and (b) taking advantage of the tax deferral and other desirable features of pensions.

For example pensions are a grand idea if: (i) you defer income tax from 40% now to 20% in retirement, or from 20% to 0%, and so on.
Or (ii) Your contributions earn employer contributions too.
Or (iii) You contribute by salary sacrifice so that you avoid National Insurance contributions.

If part of your current contribution satisfies none of (i) to (iii) then, in your shoes, I'd stop making it and instead use ISAs or, depending on the same tests, use the money to contribute to your wife's pensions. The exception would be if you are already 55 or older: then pensions lose much of their inflexibility and are a slightly more remunerative investment than ISAs as long as you avoid the LTA constraint.

[hiriskpaul]

You should distinguish two issues: (a) saving and investing enough money to support you in retirement, and (b) taking advantage of the tax deferral and other desirable features of pensions.

For example pensions are a grand idea if: (i) you defer income tax from 40% now to 20% in retirement, or from 20% to 0%, and so on.
Or (ii) Your contributions earn employer contributions too.
Or (iii) You contribute by salary sacrifice so that you avoid National Insurance contributions.

If part of your current contribution satisfies none of (i) to (iii) then, in your shoes, I'd stop making it and instead use ISAs or, depending on the same tests, use the money to contribute to your wife's pensions. The exception would be if you are already 55 or older: then pensions lose much of their inflexibility and are a slightly more remunerative investment than ISAs as long as you avoid the LTA constraint.

Pensions are tax efficient to basic rate taxpayers. eg for 100k in a pension fund, 80k contribution + 20k tax relief top-up, after taking 25% tax free pension commencement lump sum leaves 75k. 75k taxed at 20% basic rate is 15k tax. Effective tax rate 15%. Another way to think about it is 80k after tax income is turned into 85k by routing through a pension. An uplift of 6.25% compared with using an ISA.

Basic rate taxpayers should not be put off contributing to pensions. For most people pensions are more tax efficient than ISAs and carry other benefits.

[Urbandreamer]

Pensions are tax efficient to basic rate taxpayers. eg for 100k in a pension fund, 80k contribution + 20k tax relief top-up, after taking 25% tax free pension commencement lump sum leaves 75k. 75k taxed at 20% basic rate is 15k tax. Effective tax rate 15%. Another way to think about it is 80k after tax income is turned into 85k by routing through a pension. An uplift of 6.25% compared with using an ISA.

Basic rate taxpayers should not be put off contributing to pensions. For most people pensions are more tax efficient than ISAs and carry other benefits.

While everything that you say here is true, it's not the whole story. Pensions are restrictive about when you can take them. The LTA* doesn't currently apply to ISA's. Pensions also have been repeatedly subject to the whim of the government of the day.

Some, for example my wife, suffered from those whims. She had a private pension set to fund her retirment at 50. The government both changed the state pension age for women and, with SIGNIFICANTLY less justification required her private pension provider to not pay out until 55. This entailed costs, as the provider had been in the process of "lifestyling" the pension based upon the original retirement date and had to reverse the process.

Of course, on the pension side, pensions can be passed free of tax at death under 75. If over 75 they will be taxed at the marginal rate of the recipient.

As I remarked it really is a complicated and horid system. Worse is the lack of predictability about future pension legislation.

*LTA: There is a study that costs a "confortable" rather than minimum or moderate, retirment at £47.5kpa for a couple. If we assume 4% drawdown then (ignoring state pensions which some predict will not exist) the capital requirment is more than the LTA of a single pension. If we do the sums then that level of pension drawings will exceed the LTA for a single pension in just over 22 years. Ok, that would be more likely to effect single breadwinner households where the breadwinner was a higher rate tax payer, but I think it should be food for thought.
https://www.lboro.ac.uk/news-events/new ... standards/

[hiriskpaul]

Pensions are tax efficient to basic rate taxpayers. eg for 100k in a pension fund, 80k contribution + 20k tax relief top-up, after taking 25% tax free pension commencement lump sum leaves 75k. 75k taxed at 20% basic rate is 15k tax. Effective tax rate 15%. Another way to think about it is 80k after tax income is turned into 85k by routing through a pension. An uplift of 6.25% compared with using an ISA.

Basic rate taxpayers should not be put off contributing to pensions. For most people pensions are more tax efficient than ISAs and carry other benefits.

While everything that you say here is true, it's not the whole story. Pensions are restrictive about when you can take them. The LTA* doesn't currently apply to ISA's. Pensions also have been repeatedly subject to the whim of the government of the day.

Some, for example my wife, suffered from those whims. She had a private pension set to fund her retirment at 50. The government both changed the state pension age for women and, with SIGNIFICANTLY less justification required her private pension provider to not pay out until 55. This entailed costs, as the provider had been in the process of "lifestyling" the pension based upon the original retirement date and had to reverse the process.

Of course, on the pension side, pensions can be passed free of tax at death under 75. If over 75 they will be taxed at the marginal rate of the recipient.

As I remarked it really is a complicated and horid system. Worse is the lack of predictability about future pension legislation.

*LTA: There is a study that costs a "confortable" rather than minimum or moderate, retirment at £47.5kpa for a couple. If we assume 4% drawdown then (ignoring state pensions which some predict will not exist) the capital requirment is more than the LTA of a single pension. If we do the sums then that level of pension drawings will exceed the LTA for a single pension in just over 22 years. Ok, that would be more likely to effect single breadwinner households where the breadwinner was a higher rate tax payer, but I think it should be food for thought.
https://www.lboro.ac.uk/news-events/new ... standards/

I agree there are trade-offs and risks when it comes to pensions compared with ISAs. I just wanted to set out that the tax relief was still of benefit to basic rate taxpayers.

For basic rate taxpayers who are eligible, Lifetime ISAs are a good alternative/addition to regular pensions and ISAs. A tax free 25% uplift, compared with a 6.25% uplift for pension contributions.