Techzone

Pensions Awareness Day takes place on 15 September each year. The main aim is to encourage people to save enough to avoid walking into pension poverty in retirement.

At the other end of the scale, those of your clients who have already amassed significant pension savings face a different set of questions about the lifetime allowance (LTA). Come up with the wrong answers and the result may be that retirement funding is stopped prematurely.

Here we look at busting five common myths that may be contributing to the perception that continued funding above the LTA is always 'bad'. 

Myth # 1 - Contributions must stop when you reach the LTA

The key word is 'allowance'. It's not a 'limit' to funding.

There's nothing to prevent individuals from continuing to pay in - they still have an annual allowance available (£40,000 if not reduced by the tapering for high earners), allowing them (or their employer) to make contributions and get tax relief at their highest marginal rates. The LTA is not a barrier to pension saving or the growth on the investment. It's the point where you have to look at what the likely tax treatment of this additional fund will ultimately mean. In this way, it's no different to any other allowance such as the personal income tax allowance, annual capital gains tax allowance or the dividend allowance - once breached, tax will be applied.

Of equal importance for all employees, if funding is stopped, there may be no alternative form of remuneration on offer to replace the employer pension contribution. This can considerably strengthen the argument to carry on funding.

Remember, where an employer does offer alternative remuneration this will be fully taxable and the amount available to invest elsewhere will have suffered income tax and National Insurance.

Myth # 2 - There's a tax charge to pay as soon as the LTA is reached

When individuals hit the LTA with their fund….nothing happens. There's no immediate penalty. Your client just has a fund greater than the amount the allowance protects. The tax charge is only incurred when benefits are crystallised, such as when the fund is designated for drawdown.

Myth # 3 - The LTA tax charge is applied when you start to take benefits

The charge only starts to bite when there's not enough LTA to cover the fund being crystallised. Benefits are tested when they vest, also known as a crystallisation event. Each time the individual crystallises some of their pension, a percentage of the LTA is used - but the charge itself only comes into play when there's no longer enough LTA available to cover the amount being crystallised.

By phasing retirement and only crystallising the funds needed each year, the timing of the LTA charge can be managed and any charge on funds greater than the LTA delayed until age 75 (at which point uncrystallised funds will be tested along with any investment growth on crystallised funds).

Myth # 4 - The penalty for taking benefits in excess of the LTA is 55%

The charge is often expressed as 55%, but that's only payable if the excess over the LTA is taken as a lump sum (or series of lump sums). If the individual moves it to their drawdown pot instead, only 25% will be deducted from the amount crystallised (remember there is no tax free cash element). There will of course be an income tax charge when the income is ultimately taken but, if the member is only a basic rate taxpayer at this time, the overall effective rate would only be 40% (i.e. 15% less than the 55% headline rate).

But will it even be the client that'll be drawing the money? Because…

Myth # 5 - On death, there will be another LTA test on funds in drawdown

There is no second LTA test on death for funds already crystallised. So if the client dies before age 75, their beneficiaries will be able to inherit the pot without any further LTA charges. And of course, income they take will be tax free - so the only charge incurred would be the 25% LTA charge when the funds were originally put into drawdown.

If the client dies after age 75 then the beneficiaries would pay income tax at their own rates on amounts drawn. But again, including the 25% LTA charge, this could mean an effective rate of 40% for a basic rate taxpayer. If the beneficiary has unused personal allowance, there may even be no further tax to pay.

Should clients continue to fund their pension?

Bearing in mind the above points, when might it make sense for your clients to continue paying into their pensions if they have funds at or above the LTA? A major influence will be whether your client is in a workplace pension and benefiting from an employer contribution, and whether there's any alternative remuneration or reward on offer.

In the absence of an alternative, an employer contribution would seem the most beneficial - no cost to the individual, and a taxed benefit is better than no benefit at all.

Contributions after the LTA has been exceeded still attract tax relief, but will suffer the LTA charge and income tax when taken as drawdown income. But those receiving tax relief at 40% on contributions will receive same net return as an ISA after the LTA charge (assuming identical funds are chosen) if they're basic rate taxpayers when income is drawn. Funds within a pension also benefit from the fact that:

• investments held within the fund don't suffer further tax on income or gains, and
• on death, they can be passed on free of IHT to provide lump sums or pension income for any named beneficiaries. It may be that an individual doesn't need to rely on their pension savings in retirement, and there may be no point in taking money out and potentially exposing it to IHT at 40%. And if the individual dies before age 75, then after any LTA charge has been dealt with, the income or lump sum would be tax free for those beneficiaries - so potentially only a 25% charge.

Of course, contributions made by those with enhanced or fixed protection would result in forfeiture, and so these clients would need more careful attention of the pros and cons before re-starting any funding.

Summary

Ultimately, having a fund approaching the LTA, or one that has already exceeded it, doesn't mean that pension saving has to cease. A considered approach shows that there may still be reasons to continue funding, depending on the client's circumstances.