Techzone

The number of clients facing a lifetime allowance tax charge on their retirement savings is likely to increase in the coming years with the lifetime allowance (LTA) frozen at £1,073,100 until 2026.

Those approaching retirement with benefits in more than one scheme may have a decision to make in terms of which order they crystallise them.

These decisions are particularly important where a client has a mixture of defined benefit (DB) and defined contribution (DC) pension benefits as the order can affect the amount tested against the LTA, which scheme pays the charge, and how that charge is paid.

Valuing benefits and commuting pension for cash

With DC schemes, the value used for LTA testing is normally very straightforward – it's just the market value of the funds.

DB schemes are valued differently. The value used is 20 times the pension plus any tax free lump sum available within the LTA. Some DB schemes have a separately accrued lump sum, but many provide tax free cash by commuting some of the pension. For such schemes, it's important to know what commutation factor will be used as this will affect the amount of LTA used by the scheme. It's also possible that the scheme rules may limit the amount of cash that can be taken.

A tax free cash commutation factor of 20 would mean that commuting some of the pension for a lump sum would use the same amount of LTA as not taking any lump sum, as the commutation factor and the figure used for multiplying the pension for LTA purposes is the same.

But if the tax free cash commutation factor is less than 20, as is frequently the case, taking tax free cash will use less LTA than 20 x the uncommuted pension, which could help reduce or even eliminate an LTA excess.

This may lead to the conclusion that DB benefits should be taken before DC benefits to ensure that tax free cash can be taken within the LTA limit. This would mean that more or all of the LTA charge would be ultimately paid pound for pound from DC savings.

But clients must also consider if taking tax free cash from the DB scheme gives them value for money – does the LTA charge saved compensate for the value of the pension benefits lost?

If the tax free cash commutation factor is over 20, more LTA will be used, perhaps compounding the problem. In this situation it may be worth considering taking DC savings before the benefits under DB.

Commutation factor for LTA tax

Where to take tax free cash from is only half of the story. Clients with DB and DC benefits must also consider which scheme they want to pay any LTA charge. The LTA charge will normally be paid by the scheme administrators.

For DC schemes the tax charge will simply reduce the value of the fund pound for pound.

But for DB schemes, a commutation factor will be used to reduce the guaranteed pension to produce the cash needed to pay the LTA charge. The factor used may be different from that used to calculate tax free cash under the scheme rules, but the principles are the same.

Once the factor has been confirmed, a decision can be made on whether it represents good value or not.

Guaranteed income versus flexibility

For those with LTA issues, the security of a guaranteed income may not be so much of an issue as it would be for those with less wealth - but it's still a point to consider.

Where a certain level guaranteed income is required, it's important to determine how much DB pension would have to be given up if the LTA charge was to be paid from the DB scheme.

Alternatively, a client may place more value on the flexibility available under their DC arrangements, for both themselves and their beneficiaries, so may prefer to have their DB benefits reduced to pay the tax on their LTA excess.

Of course, there may be other considerations too - for example, where there is protected tax free cash or disqualifying pension credits which mean that tax free cash will be more or less than 25% of the fund.

In addition, where the focus is on wealth transfer on death, if the LTA charge falls on the DB scheme, there could be more DC savings for the family to inherit.

Summary

The order in which schemes are crystallised will depend on each client's circumstances as there are several considerations. There is no set order that will apply to all.

But the ability to choose the order in which benefits will be tested does give clients control. They can determine which scheme will pay any LTA tax, and sometimes also the amount of tax due.

Where there are DB benefits involved, it's therefore vital to understand the benefit structure and also the commutation factors that will be used, for both tax free cash and LTA tax.