Chris Jones and John Woolley examine the pros and cons of crystallising pension funds when near to the lifetime allowance
For those over the minimum vesting age of 55, with large defined contribution (DC) funds near or in excess of the lifetime allowance (LTA), the decision regarding when to crystallise can be complex. As well as trying to manage any LTA charges, clients must also consider their income needs, their income tax position and any inheritance tax (IHT) consequences, along with wider estate planning objectives.
The reduction in investment values this year caused by the coronavirus has led many clients to question whether this presents an opportunity to crystallise now, or perhaps sooner than they may have originally intended, to try and minimise any later LTA charges. The fall in values may also provide scope to consider further contributions.
Here we examine the pros and cons, relevant issues and planning opportunities for a typical person with substantial pension funds who is yet to crystallise some or all of their funds.
Working through an example case study, we believe, helps to identify the key planning points to consider in terms of choosing when to crystallise and other important factors such as the LTA on death benefits and the LTA charging options.
Tom is 56 and is as a senior engineer for a large construction company, earning about £80,000 a year as well as various benefits and bonuses. He decided to opt out of his employer’s DC pension scheme as he was concerned about the LTA. He had a large DC fund worth £1.2m, which was the result of a transfer from a defined benefit (DB) scheme he had with his previous employer. With the fall in markets, Tom’s fund has fallen in value to about £960,000 and Tom wonders whether he should crystallise his funds now to avoid an LTA charge.
Tom’s estate is currently worth £1.3m, with a house and contents valued at £800,000 and ISA/collectives/share investments of about £500,000. He enjoys his work and currently has no plans to retire. He is married and has two children in their early 20s. His wife Annie is 53, works for the local authority and has a DB pension.
If possible, he would like residual pension funds to pass to his children in the most tax-efficient way possible, but would also be interested in accessing funds to help them with house deposits.
We will consider three broad options in terms of when to crystallise:
- Crystallise the funds now
- Crystallise at the point the funds are equal to the LTA
- Leave the funds uncrystallised until they are needed, or until age 75.
There are of course variations within each of these, with options such as to partially crystallise or to crystallise up to the LTA if the funds exceed the LTA. However, these options demonstrate the key differences in terms of the planning points.
As Tom is older than the minimum pension age of age 55, he can choose to crystallise the funds now. This would involve taking the pension commencement lump sum (PCLS) tax-free cash amount of £240,000 and moving £720,000 into drawdown. The crystallisation would use up 89.46% of the current LTA (£960,000 of £1,073,100), leaving Tom with 10.54% remaining.
Clearly, this avoids an immediate LTA charge. However, there are significant downsides as follows:
(i) Tom has not maximised his tax-free cash. By crystallising early, he has received £240,000 tax-free cash, which is £28,275 less than the maximum possible based on the current LTA (ie 25% of £1,073,100). He can now only benefit from the maximum amount if he makes further pension contributions.
(ii) The £240,000 PCLS has been removed from the tax-efficient wrapper of the pension funds and so, if invested, is exposed to income tax and capital gains tax (CGT). Moreover, the invested cash now falls into his estate. He has no apparent immediate need for this money, so this is now exposed to a potential 40% tax on death, whereas it could have remained outside of his estate within the pension fund. Indeed, this £240,000 could result in additional IHT of £96,000.
If Tom wanted to give some of this money to his children, he could use the tax-free cash to achieve this. As long as he is in good health, he will hopefully survive the seven years required from the date of the gift for it to fall outside of his estate. However, he could instead use his existing investments to achieve this and reduce his estate, while keeping his IHT-free pension funds intact.
Tom has 10.54% of the LTA remaining, which based on the current LTA gives him £113,105 of headroom to cover any growth on his drawdown fund. The LTA should increase with CPI, so while the percentage available remains constant, the monetary amount should increase each year. However, by crystallising the funds he has lost the inflation protection on the amounts physically crystallised.
Crystallising the funds now allows Tom to control any LTA charge at the point of the second LTA test, which will occur either when Tom reaches age 75, or if he chooses to use his drawdown funds to purchase an annuity before then. If the growth on the funds in drawdown starts to exceed his remaining LTA, he can start to take income. However, the income will be subject to income tax in the year it is received. It would also trigger the money purchase annual allowance of £4,000, which would be an issue if Tom was considering making further contributions. Currently, Tom does not require any additional income and, if he takes income while in his current financial position, it would be subject to high rates of income tax, possibly pushing his income over the £100,000 personal allowance threshold. A key consideration will be if and when Tom 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.
Crystallised as the fund reaches the LTA limit
An alternative strategy could be to crystallise at or near the point at which the funds reach the LTA. The advantage with this option is that he will maximise the tax-free cash available at the point of crystallisation. He may also be able to benefit from several more years of CPI increases to the LTA and so have both a higher LTA amount and a higher tax-free PCLS.
For example, if no further contributions are made, the fund grows at 4% pa and the LTA grows at 2% pa, it would take just over five years for the current fund value to equal the LTA at just under £1,185,000. This would give Tom
more than £50,000 of extra tax-free PCLS than if he crystallised now.
This option can be adopted regardless of whether further contributions are recommenced or not. (This is considered below).
This option avoids an immediate LTA charge and ensures both the tax-free cash and the LTA are maximised at the point of crystallisation. However, it still has the downside that the tax-free cash amount is removed from the tax-efficient environment of the pension fund and is also brought into the estate, so could be subject to IHT if not given away or spent before Tom dies.
While this option still provides Tom with control, he will have used 100% of his LTA, leaving nothing available at the time of the second LTA test. Therefore, he would have no headroom for growth on the funds in drawdown. Taking the full LTA also means there is no further inflation protection on the funds. At the point of the second LTA test, any growth on the funds placed in drawdown will be subject to the LTA charge. Again, he can control this by taking income but would need to consider his income tax and IHT position at that time.
Leaving funds uncrystallised until required or age 75
A third option would be to leave the funds invested and not crystallise until either funds are required, or at age 75 when all uncrystallised funds are tested against the LTA.
Here, Tom does not aim to control the LTA, but just accepts that it may apply. Tom currently has no need for capital or income and it is unclear when he will. It may be possible that he does not require his funds for many more years. He may also decide to use his other investments to fund any income shortfall during the early years to reduce the value of his estate.
While there is likely to be an LTA charge, assuming the funds grow at a greater rate than inflation, the advantage of this is that the funds all remain outside of the estate for IHT purposes. This option also ensures that the funds maintain the full inflation protection of the annual increases in the LTA. It will also mean that there is flexibility on taking income, which means it can be taken as any when required, so is less likely to suffer high marginal rates of income tax.
Tom can of course monitor and review this strategy at any point. If he chooses, or needs, to access the tax-free cash PCLS and/or income before age 75, he can decide at that point whether to crystallise all the fund or just take up to the LTA at the time. If he has no need for the excess above the LTA, he can leave the funds in the pension, suffer the 25% LTA charge at age 75 and leave the funds to pass on to his children on death free of IHT (although potentially subject to income tax on withdrawal if Tom dies aged 75 or more).
The LTA charge – 55% v 25%
Where the LTA is exceeded through crystallisation before the age of 75, the client has the choice of paying a 55% tax charge on the excess if the funds are taken as a lump sum, or 25% if designated to drawdown to provide income. Any withdrawals will of course be subject to income tax when drawn.
The two routes are broadly neutral for a higher rate taxpayer, as 40% of 75% will leave the member with
45% of the original amount – though the tax charge is paid at different times. However, basic rate taxpayers will be better off. Conversely, additional rate (45%) taxpayers who remain so, may be better off paying the 55% tax charge on the excess on a lump sum withdrawal. Of course, all of this assumes tax rates will remain the same going forward. 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 tax threshold, this is no longer always the case and the 25% drawdown designation option has become more popular. At age 75, there is no lump sum option and the 25% charge is applied.
Gifts using ‘normal expenditure out of income’ exemption
Should Tom be financially secure, so that he knows that he would not need all of the income from the drawdown fund, he could consider drawing it and gifting it to his children on a regular basis and thus using his IHT normal expenditure out of income exemption. On the basis that the exemption applies, those payments would then be immediately outside of his estate without the need to survive for seven years. Taking income and gifting it in this way can help control the growth of the funds for the second LTA test without the downside of increasing the value of the estate.
One important point in this case study is that the income would still suffer high marginal rates of income tax if Tom were to do this now. However, this strategy could be adopted later when Tom decides to give up work. Tom would need to consider both his and his likely beneficiaries’ marginal rates of tax and his state of health. If he were to die before the age of 75, leaving the funds in the pension fund would be more beneficial. Another key consideration is that Tom may well want to provide funds to his children sooner rather than later, for example,
to help them save for house deposits or assist with mortgage payments.
Crystallised funds are not subject to a further LTA on death before age 75. This provides an LTA advantage over leaving the funds uncrystallised. For example, if Tom crystallised at age 60 when the funds were equal to the LTA at the time, any growth on the funds between the date of crystallisation and death before the age of 75 would be free of an LTA charge. Assuming the funds grow at a faster rate than the CPI increases in the LTA, this could result in a substantial tax saving compared to leaving the funds uncrystallised.
This has to be weighed up against the disadvantages mentioned above, ie the tax-free cash if taken would be a part of his taxable estate and he would lose the CPI inflation protection in the event he survives to age 75 and is subject to the second LTA test.
Once over 75, there are no further LTA tests on death and all lump sum benefits are subject to an income tax charge at the beneficiaries’ marginal rates (45% for trusts). The difference would be that where the funds remain uncrystallised, the entitlement to the PCLS tax-free cash is lost on death. However, this needs to be weighed up with the fact that all the funds are outside of the estate, whereas the tax-free cash would not be unless it was spent, given away or invested in an IHT plan. When considering deferring tax-free cash beyond age 75, consideration needs to be given to the IHT position, the health of the client and the likely tax rates of the beneficiary or beneficiaries. In some cases, it may be better to take the tax-free cash and give it away, or invest it into IHT-efficient assets.
Making further contributions
Regardless of which option is chosen, Tom should also reconsider whether to join his company pension or not. If he were to crystallise now, further contributions offer the clear benefit of ensuring he maximises his PCLS tax-free cash. However, even in cases where the value of Tom’s fund exceeds the LTA, it may still be worth joining the scheme. The benefit of joining the scheme will depend on the terms on offer and whether there is a cash alternative for those who choose not to join the scheme. If there is none, then it is likely that joining the scheme and suffering any LTA charge will be more beneficial than not receiving anything.
Tom will still receive higher rate tax relief on any personal contributions and if he can take his benefits while a basic rate taxpayer, the position on these is neutral. For example, a £100 contribution would cost him £60. If it is all subject to a 25% LTA charge, then this would give £75. If this is then taken and taxed at basic rate tax, this would give a net value of £60. On top of this, there would be any employer contribution, less the LTA charge and income tax. Furthermore, there are IHT advantages in maximising cash in the pension plan.
When making additional contributions around the same time of taking tax-free cash, consideration needs to be given to the tax-free cash recycling rules.
Where clients have LTA protection in place
Most of the same planning considerations will apply where the client has a higher protected LTA in place (such individual or fixed protection). A key difference in such cases is that the inflation protection of the LTA will not then be so relevant.
Depending on the client’s level of protection, it may be that the standard LTA is unlikely to exceed their protected LTA before they reach age 75, for example if they are in their late 60s and have fixed protection at £1.8m. This reduces the disadvantages of crystallising earlier, but the other key considerations remain, such as how bringing cash back into their estate will affect their IHT position.
This article has aimed to highlight the key planning considerations for clients with uncrystallised defined contribution pension funds who are near or over their LTA limits. Clearly this is complex area of planning and there is no one size fits all solution. In each case advisers need to consider the client’s individual circumstances, including their need for income from the pension, their marginal income tax rates both now and in the future and their IHT position. Although planning can help minimise or remove an LTA charge, sometimes accepting the charge may provide the better outcome. Estate planning in particular, has become an increasingly important aspect of pension planning and the advantages provided by a pension plan can outweigh the disadvantages of an LTA charge. ●
Chris Jones and John Woolley of Technical Connection / St. James’s Place