Lifetime allowance - how benefits are tested

Every individual has a single lifetime allowance against which their benefits are tested when a benefit crystallisation event happens. This case study works through those checks for various types of pension plan

The lifetime allowance limits the amount of savings built up in a tax advantaged environment. Although there is no limit on the amount of authorised benefits an individual can hold in a registered pension plan. Every individual has a single lifetime allowance against which their benefits are tested when a benefit crystallisation event happens.

These include:

  • taking an income
  • taking lump sums
  • reaching age 75
  • dying and
  • transferring to a qualifying recognised overseas pension scheme (QROPS)

This case study shows how this test is applied on different types of pensions at various benefit crystallisation events.

Aaron is 64, married to Amy.  They have a grown-up son who does not live at home.  Aaron plans to retire when he is 65.

He has 3 pension arrangements:

  • A pension from his 22 years in the forces, which he started to draw in 1994, when he received a lump sum of £24,650 and a pension of £7,350 p.a., which has increased to its current rate of £11,905 p.a.
  • He will have 26 years’ service with a major security company where he is a head of department at age 64.  His defined benefits (DB) scheme is a 1/60th scheme with an NRD of 65 and his pensionable salary is £69,500.  He pays 6% of pensionable salary towards his scheme.
  • Aaron also has a personal pension which has recently been valued at £250,000.

When he reaches age 65, he will start to take his DB scheme pension benefits with the security company.

How much lifetime allowance will he use?

All examples of benefit crystallisation events in this case study use £1,073,100 as the lifetime allowance, but normally you’d use the current lifetime allowance.

Taking this DB pension will be a benefit crystallisation event, so a lifetime allowance calculation must be done.  Pension benefits in payment before 6 April 2006 (also known as pre-commencement or pre A-Day pensions) were not subject to a lifetime allowance check, but if he takes further benefits on or after 6 April 2006, the benefits already taken are also counted towards the lifetime allowance used.  This is calculated immediately before the first benefit crystallisation event on or after 6 April 2006 and so reduces the member’s amount of lifetime allowance available for the first benefit crystallisation event.

HMRC PTM 088300 The lifetime allowance and the lifetime allowance charge: benefit crystallisation events: pensions in payment on 6 April 2006

The value used depends on what type of pension the pre 6 April 2006 pension is. 

We first look at his armed forces pension.  If this was the only pension he had, there will be no benefit crystallisation event as it’s a pre 6 April 2006 pension, and as there was no lifetime allowance then there’s no lifetime allowance test, but as soon as he takes his benefits from his DB scheme with the security company it’s a benefit crystallisation event and an lifetime allowance test is carried out. 

Note: There will never be a lifetime allowance charge against any pre 6 April 2006 pension as valuing a pre-commencement pension is NOT a benefit crystallisation event.

The pre 6 April 2006 scheme pension is valued at 25 x annual pension amount at the date of the first post 6 April 2006 benefit crystallisation event.  Pre 6 April 2006 pensions are valued at 25 rather than 20 as the individual is expected to have taken a tax-free lump sum when the benefits were taken.
He doesn’t have any lifetime allowance protection, his pre A day scheme pension of £11,905 p.a. is in payment when he takes the DB pension (the current value at time of crystallisation is used - NOT the value at 6 April 2006). The lifetime allowance at the date of the benefit crystallisation event is also used.
  • The pre 6 April 2006 pension uses up 25 x £11,905 = £297,625. 
  • To calculate the percentage of the lifetime allowance used up will be £297,625/1,073,1001 = 27.73%.  So, he has used up 27.73% (round down for lifetime allowance purposes) of the lifetime allowance.

He will then need to have his DB scheme benefits valued, which will be 20 times plus any tax-free cash, not provided through commutation of pension benefits - benefit crystallisation event 2.

He only wants to take a pension so it will be valued at 26/60 x £69,500 x 20 = £602,333.33.

The percentage of the lifetime allowance will be £602,333.33/£1,073,100 = 56.13%

So, at this point 83.86%, 27.73% plus 56.13%, of his lifetime allowance has been used up. As he has only used up 83.63% of his lifetime allowance there is no lifetime allowance charge.

Death under 75 with uncrystallised funds

4 years later at age 69 he dies.  Death before age 75 will be a benefit crystallisation event.  He still has his uncrystallised personal pension which his wife wants to designate to beneficiary drawdown, so another lifetime allowance calculation is done at this point.

The valuation amount for the benefit crystallisation event is the value of the pension - benefit crystallisation event (5D).

The fund has grown from £250,000 to £281,832.2

£281,832.00/1,073,1001 = 26.26%

So, all the values need to be added together to find out the total lifetime allowance used.

Forces pension £297,625 27.73%
Security company pension £602,333.33 56.13%
Personal pension £281.832.00 26.26%
Total £1,181,790.3 110.12%

As the total percentage used is 10.12% over the lifetime allowance, that percentage of the lifetime allowance is liable to a charge.

£1,073,1001 x 10.12% = £108,583.02

On death the liability for the tax charge lies solely with the beneficiary. The legal personal representative of the deceased is responsible for gathering the necessary information to determine if there is a lifetime allowance excess. They must then inform HMRC who will contact the beneficiaries to request payment of the tax, who will pay it from the death benefits received.

The lifetime allowance excess tax charge is 55% (£59,720.66) if taken as a lump sum or 25% (£27,145.76) if used to provide pension income such as drawdown or an annuity.

As he died before age 75 any income or lump sum will be income tax free.3

It would therefore make sense for the beneficiary to take the benefits as beneficiary drawdown, paying 25% on the excess over the lifetime allowance with no further tax on withdrawals of any size from the plan.

Death over 75

If he died over age 75, the beneficiary will have income tax to pay at their marginal rate, but there will be no further lifetime allowance test as they will have already been tested at age 75.

If he had successfully applied for fixed protection 2016 when he stopped accruing, and retained it, his lifetime allowance protection for all his pensions would have been £1,250,000 and therefore in the scenario above where the lifetime allowance used up was £1,181,790.34 there will have been no lifetime allowance charge as it was under the protected lifetime allowance of £1,250,000.

Age 75 test – uncrystallised funds

At age 75 a final test is done against the lifetime allowance. What’s tested at age 75 is:

  • any uncrystallised defined benefit pension rights
  • any uncrystallised defined contribution rights
  • any growth in a drawdown plan since it was set up

The only benefit crystallisation event that can happen after age 75 is where a scheme pension in payment is increased beyond a permitted margin, which would be unusual. He reaches age 75 and has an uncrystallised personal pension, so at age 75 a final test is done against the lifetime allowance - benefit crystallisation event (5B).

Forces pension £297,625.00 27.73%
Security company pension £602,333.33 56.13%
Total £899,958.33 83.86%

A total of 83.86% of the lifetime allowance has already been used, so say the value of the personal pension is now £337,338.

£337,338/£1,073,1001 = 31.43%

Forces pension £297,625.00 27.73%
Security company pension £602,333.33 56.13%
Personal pension £337.338.00 31.43%
Total £1,237,296.33 115.29%

As the total percentage used is 15.29% over the lifetime allowance, that percentage of the lifetime allowance is liable to a charge.

£1,073,1001 x 15.29% = £164,089.02

25% x £164,089.02 = £41,022.26 tax charge to pay.

Age 75 test – income drawdown

Some years previously he crystallised his personal pension designating the funds into drawdown. When he reaches age 75 a final test is done against the lifetime allowance on the growth in the value of the drawdown fund - benefit crystallisation event (5A).

The pot was £270,000 and he took 25% PCLS of £67,500.   The remaining pot of £202,500 was crystallised into drawdown, so there was a benefit crystallisation event then which exceeded the lifetime allowance. 

At age 75 the drawdown pot had grown from £202,500 to £242,382.06 resulting in the growth of £39,882.06.

He was already over the lifetime allowance when he went into drawdown and paid a lifetime allowance charge as it was a benefit crystallisation event, but the growth of £39,882.06 is also tested at age 75.  At 75 the tax payable is 25%, as a lifetime allowance excess lump sum is not available at age 75.

£39,882.06 x 25% = £9,970.51 tax charge to pay.

When death is after age 75 there is no further lifetime allowance test for crystallised or uncrystallised as the funds were already tested at age 75, other than where a scheme pension is increased beyond a permitted maximum.

1 the current lifetime allowance has been used for illustrative purposes, as we cannot predict the lifetime allowance in the future. The lifetime allowanced will normally be the lifetime allowance for the year the benefit crystallisation event took place.

2 3% compound no charges.

3 if settled within two years of the members death.

Further information

Why paying a tax charge isn't always a bad thing?

Note

The information provided is based on our current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice. Also it may not reflect the options available under a specific product which may not be as wide as legislations and regulations allow.

All references to taxation are based on our understanding of current taxation law and practice and may be affected by future changes in legislation and the individual circumstances of the investor.

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The Royal London Mutual Insurance Society Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. The firm is on the Financial Services Register, registration number 117672. It provides life assurance and pensions. Registered in England and Wales number 99064. Registered office: 55 Gracechurch Street, London, EC3V 0RL.