Techzone

In these extraordinary times the increase to the Lifetime Allowance (LTA) in line with CPI to £1,073,100 went largely under the radar.

At the same time, retirement savings have been dented by falling markets on the back of the pandemic.

Taken together, this may prove a catalyst for some clients to bolster their retirement savings by increasing or recommencing pension contributions, or indeed look to alternative homes for their retirement savings.

New pension savings may be caught by a LTA charge when the resulting benefits are taken, an increasing possibility should markets rebound to pre-Covid19 levels. The thought of a tax charge will undoubtedly be off-putting for some people.

However, when making decisions, clients should be reminded that the possibility of an LTA charge is not necessarily a signal to put the brakes on future pension savings.

If the net returns on savings in excess of the allowance are still greater than saving elsewhere then a little extra tax may be a price worth paying.

Any client faced with the prospect of exceeding their LTA has some difficult decision to make and, of course, the best course of action will depend on their individual circumstances:

• Should they give up their employer pension contributions?
• Does carrying on paying matching contributions make sense?
• Will they be better off taking up their employer's offer of extra salary in exchange for pension contributions?
• Should they stop paying into their pension if this will lead to a tax charge on savings in excess of the LTA?

Important considerations

This table summarises what should be considered when making this important decision.

Fixed Protection

Anyone who still has valid fixed protection will of course lose this if there are any new payments into their pension. This includes those who re-join their employer's auto-enrolment scheme, even if the employer pays all the contribution, or if they're enrolled into a new employer's scheme. With the LTA currently at £1,073,100 for 2020/21, this could mean losing up to £176,900 of LTA protection. So, for those affected, it's clear that there's a trade-off between an increased LTA and the loss of future funding from the employer. Critical factors will be how near the individual is to their expected retirement date and how close their pension funds are to the standard LTA.

The loss of employer funding

Clearly, one of the key elements influencing choice will be the value of the employer contribution, which might also depend on the employee making contributions. Many employers offer matching contributions. So if your client stops funding, will their employer stop funding too?

Employer pension contributions are essentially 'free money'. Even if they suffer an LTA charge of 55% on their entire future employer funding, they should still be better off as they're receiving 45% of something they would otherwise miss out on. It may therefore make financial sense for most to continue their own funding to retain the funding from their employer, despite the LTA charge

Alternative employer remuneration package

The picture may change if the employer is prepared to offer additional salary instead of making pension contributions. It's a situation which can arise in the private sector, but unlikely to happen for public sector employees.

But much will depend on what the alternative offer is and the associated tax and NI on it. The employer may only be prepared to offer an amount which equates to the same net cost as the pension contribution (i.e. after employers NI liability).

For example, a higher rate tax paying employee receives an annual employer pension contribution of £40,000. After deduction of employer NI at 13.8%, that would equate to additional salary of £35,149. The employee then has income tax and NI to pay on the additional salary, so the amount they receive would be £20,386.

The question is then where to invest it?

• ISAs - generally the next best thing to pensions in terms of the tax advantages they enjoy. No tax relief, but fund growth is free of CGT and income tax and there's no tax when accessing the funds. The only real downside is that contributions are limited to £20,000 each year.
• Offshore Bonds - these enjoy the same tax free gross roll up as both pensions and ISAs. However, on surrender any gains will be subject to income tax.
• Mutual funds - these pay corporation tax on non-dividend income received within the fund. But clients may be subject to income tax on dividends or interest distributions and capital gains tax on investment growth.

The table below shows what the client might get back by investing the net pay of £20,386 over five years into another investment wrapper with the same gross roll up and achieving a 2.5% real rate of return. (This is for illustrative purposes as the net pay is greater than the current ISA allowance, but this could still be achieved by using a spouse's allowance.)

* After LTA charge of 25% + 40% income tax on balance if taken as income
** After LTA charge of 25% + 20% income tax on balance if taken as income

This shows the difficulty of the decision faced. A key factor is the likely tax position of the client when funds are withdrawn. If pension income would all be taxed at higher rate, it's clearly better to take the extra salary and invest it elsewhere. But if income can be extracted from the pension at basic rate, then it swings more in favour of funding beyond the LTA even with the 25% tax charge.

Making personal contributions that result in an LTA charge

Funding above the LTA certainly makes sense where it means retaining employer funding. But what about making personal contributions which will result in an LTA charge? There's something that feels slightly uncomfortable about paying contributions knowing that an additional tax charge will be applied. What really matters though is what clients will get back after all taxes have been deducted.

That will depend upon their rate of tax paid in retirement. If income in retirement can be kept at basic rate then personal contributions receiving 40% tax relief, even after the LTA charge, will achieve exactly the same return as an ISA.

The table below compares what the client might get back in their hand assuming a real rate of return of 2.5% over 10 years for the same net cost of £15,000.

However, on death the pension is generally IHT free, whereas both the ISA and offshore bond will form part of the estate for IHT, potentially being taxed by a further 40% on death.

Summary

It's only natural to want to limit tax charges of any kind, especially one designed to act as a cap on funding. But it's always important to look at all the options in the round. The alternatives will generally have their own tax consequences to be worked through before arriving at the most suitable outcome for the client.