Sally took her defined benefit scheme at 65 and the tax-free cash from her Sipp three years later. The rest went into drawdown. She has no lifetime allowance (LTA) left and no protection.
Sally is now approaching her 75th birthday, when she will face a second crystallisation event. The amount tested against the LTA is the value of her income drawdown plan now less the value when it was first set up. In other words, the amount of growth in the plan. Any excess is taxed at 25% (never at 55%).
When Sally set up her income drawdown plan it was worth £100,000. Now it is worth £147,000, a difference of £47,000. She is now liable for an LTA charge of £11,750 (25% of £47,000).
Sally could avoid the charge by taking out enough drawdown income to reduce her plan to below its original value of £100,000. To do that, she could withdraw £47,000 in the run up to her 75th birthday. Paying 40% income tax on the payment means an income tax charge of £18,800, which would leave £28,200 in her pocket.
If Sally needs the money, the most tax-efficient solution is to take the income payment before the age of 75. Otherwise, if she leaves the withdrawal until after that date, she faces both an LTA charge and an income tax bill.
Sally could also avoid an LTA charge by switching to a more cautious investment strategy to minimise growth.
Taking the hit
But what if Sally does not need the income and instead wants to pass the excess onto her niece Chloe, who is 56?
If Sally takes the hit and pays the LTA charge due at the second crystallisation event, that leaves £35,250 in her Sipp. On her death, the pension plan would normally fall outside the estate for inheritance tax purposes. If Sally has nominated Chloe on her expression of wish form, Chloe can normally take this pension money either as a lump sum or as a pension income. She pays tax at her highest marginal rate. Or Sally could just leave it in the beneficiary’s drawdown.
Chloe is a basic-rate taxpayer. Therefore, the excess amount of £35,250 left in Sally’s Sipp will be taxed at 20% if it is taken out gradually as income, which leaves £28,200.
Another option is for Sally to take the excess out before her 75th birthday, pay the income tax and then pay £28,200 back into Chloe’s pension pot as a third-party contribution. As long as she takes care, she can set up this payment under the normal expenditure rules for inheritance tax. Chloe will receive 20% tax relief on the contribution, which makes it a gross contribution of £35,250. As she is over 55, she can withdraw this money and 25% will be tax-free. The rest will be taxed at 20% if taken out gradually. If it is, she will miss out on any future tax-free investment growth in the pension.
Rachel Vahey is a senior technical consultant at AJ Bell.