I started my career in financial services in the 1990s, not long after heavy rock bands L.A. Guns and Hollywood Rose merged to form Guns N’ Roses (the equivalent in the financial world was Royal Insurance and Sun Alliance becoming RSA in 1996).
I loved listening to 1990s music, and still do. My finance career was an Oasis, and I had plenty of Verve and ambition. One of my first jobs was undertaking maximum funding checks, which involved checking that companies were not putting too much money in their pension schemes. How times have changed.
My career in finance has been a Blur, and now sees me checking whether people have too much or too little in their pensions almost every day of my life.
Why? In 2006, the annual allowance governing what individuals could save tax-free into their pensions arrived. Back then, it was £215,000 (a far cry from the £40,000 or less it is today). However, getting full tax relief on such enormous sums was felt to be 2 Unlimited, so the government introduced a second cap in the form of the lifetime allowance.
This currently stands at £1.07m. It will be higher for individuals who have previously taken out lifetime protection (enhanced, primary, fixed or individual). Breach that amount, and you will have some extra tax to pay.
Somewhat controversially for a wealth manager, I believe that triggering a tax charge by breaking a threshold should be seen as a great thing. It means you have done well, as with most taxes. Usually, paying no tax whatsoever means nothing good has happened (even I can only get clients down to about a 4 per cent tax rate in retirement). So you should pat yourself on the back, this is The Wonder Stuff, you have saved and invested well.
However, the wealth management industry stokes the fear of this dreaded 55 per cent tax charge. Yes, people with defined contribution (DC) pensions will pay 55 per cent if they take the excess above the lifetime allowance as a lump sum. But why would you do that? You do not want to just Pulp your money.
So what happens if you choose the income route? Let’s assume your DC pension fund is £100,000 in excess of the lifetime allowance. For a higher rate taxpayer, the 25 per cent lifetime allowance tax charge on that £100,000 leaves £75,000. When this amount is taken as income, it is taxed at 40 per cent (resulting in a further £30,000 tax bill). This leaves you with £45,000, meaning an ‘unbelievable’ (as EMF would say) total tax bill of 55 per cent.
There are ways that a higher rate taxpayer could avoid this tax charge. For example, you would be far better off drawing the funds if you can manage your annual income down to the level of a basic rate taxpayer (and taxed at 20 per cent) and make use of the £12,500 personal allowance (0 per cent tax).
Another popular choice is to leave it to a non-taxpayer (a grandchild, perhaps). Under the current rules, you can leave DC pensions to whomever you wish, and they will not be counted as part of your estate for inheritance tax (IHT) purposes. The beneficiary can take the pot, or an income from it, at their marginal rate of tax. Yes, they would have to pay the 25 per cent lifetime allowance charge on the excess. But considering the overall tax advantages, there is No Doubt they are getting a good deal.
In my experience, there are two scenarios which cause people worry.
The first being, what should they do if their pension pot exceeds the lifetime allowance? Unless you have crystallised your DC pension (ie started taking benefits from it) then this is a problem for the future. You could look at the pros and cons of taking the funds in excess of the lifetime allowance as income (see above). This will more than likely cause a 25 per cent tax, then a 40 per cent tax. It will also bring funds into your estate for IHT purposes.
So for most, the most tax efficient approach is sit tight and work on finding that non tax paying beneficiary.
But let’s step back for a second. If you need the money to spend, then ignore the tax. Spend it! After all, that was the ultimate purpose of saving. It is incredible how many people I speak to about lifetime allowance issues who have never thought about it this way. Do not tie yourself up in knots with tax, spend the money, enjoy yourself and have fun. You are the most important person, not your Offspring.
The second issue is a slightly more taxing one — that is, if you are about to breach the lifetime allowance. The reason this is so problematic is that if you are at the lifetime allowance and your fund falls £10,000, you feel every penny of that fall. Yet if it rises by £10,000, at best, you will only benefit from £7,500 of that increase.
Therefore, the risk and return is disproportionate. This is an unusual situation. If you are approaching retirement then this should be in your mind. Look at the risk you are taking. Try to manage the risk around this level, but (and as an adviser, I would say this) seek advice.
How the lifetime allowance interacts with final salary (defined benefit) pension schemes is more complex. I have heard many advisers say that transferring out (swapping your regular income for a lump sum) is a ‘no-brainer’. This is an actuarial calculation, taking weeks to formulate, for the benefit of the scheme, not the individual. So please go into the process with an open mind.
The lifetime allowance may have a huge impact on the transfer of a final salary scheme. There are some heady multiples on offer; if you have a final salary pension worth £10,000 a year, the scheme could offer you as much as £450,000 if you transfer out.
The way that the lifetime allowance is calculated on final salary pensions is different (usually, a multiple of 20x income in the first year, plus your lump sum). You could well find there’s more tax to pay if you transfer to a DC arrangement.
The tax rules surrounding pensions could well cause you to Rage Against the Machine. I don’t know why we need both an annual and lifetime limit on pension savings, and don’t get me started on the pensions taper. This complexity isn’t helpful, but it does keep me in a job.
In conclusion, there is only one thing worse than a tax bill . . . and that is an unexpected tax bill. So analyse your current benefits, look at the requirements you have for your fund, and estimate the tax. In most situations, using cash flow modelling to work out the best solution for your circumstances will allow you reach the Nirvana of retirement.
Michael Martin is private client manager with Seven Investment Management (7IM). The views expressed are personal. Twitter: @7IM_MichaelM