Today, we’ll dig a little bit deeper, to see how we might avoid paying HRMC an extra 25% of our hard earned savings. I’m going to focus on the benefit crystallisation event at age 75, where your entire pension balance is tested against the Lifetime Allowance – the principle applies to the other benefit crystallisation events too, it’s just conceptually simpler to think about a single test.
We’ll start the analysis by assuming that you haven’t touched your pension before age 75, you’ve just let it grow – maybe you’ve drawn a retirement income from other savings, Social Security, State Pension, etc. Then we can expand to look at what happens if you draw from your pension before 75, like many of us will want to.
We’ll also only look at defined contribution plans – defined benefit plans are also subject to the Lifetime Allowance, but it works a bit differently. And we’ll assume UK pensions are subject to US tax (not much changes if they aren’t – the US doesn’t care about the Lifetime Allowance, but some of the management strategies might have US tax impacts).
Bottom line up front: it’s nice to try to avoid or minimize the 25% penalty, but don’t let it overwhelm the basics of investing for growth and a comfortable retirement.
What happens if you do nothing?
If you have a pension/SIPP balance greater than the Lifetime Allowance (£1,073,100 in 2021, and frozen there until 2026 at least), the excess is subject to a penalty tax of 25%. For the test at age 75, this 25% charge would be assessed when you turn 75 – you’re still subject to income tax when you withdraw the money from the pension.
- There’s also a 55% penalty option, which only applies if you take money in excess of the Lifetime Allowance as a lump sum. But this money isn’t subject to income tax later, so it’s basically the same as paying the 25% penalty and 40% income tax (£100 with the penalty tax at 25% leaves £75, which is then subject to 40% income tax, leaving £45 – the same as a 55% tax).
- I’ll just call it a 25% penalty in the rest of this post for the sake of simplicity.
This 25% penalty basically limits the amount of money that the government is prepared to treat in a tax advantaged way – they want to incentivize savings for retirement, but not give too many advantages to the “rich” (we can debate if £1M in a pension saved over a lifetime of work is really “rich”, but that’s a topic best addressed over a pint).
You also can only take the 25% tax free pension commencement lump sum (PCLS) up to 25% of the lifetime allowance – so you can get £268,275 UK tax free, but not above that.
When should you care?
Simply, if you think you’ll have more than £1,073,100 in your pension – either all at one time, or if you take out some and leave enough to grow that your withdrawals plus the remainder (growth in your drawdown and the full balance in your main pot) is over the limit. The calculations get complicated, but a few examples of where you’d get to the limit – anything over these would be subject to the 25% penalty.
- 6.5% average real growth rate, saving £2,500 a year (about 8% of the median UK salary) from age 22 to age 68
- 5% growth rate, save and grow enough to have a £100k balance when you turn 30, and then you don’t touch it again for the next 45 years
- 6% growth rate, save £10,000 a year in your 30s, never touch your pension again
- 5% growth rate, saving £20,000 a year from age 45 to 65
Obviously we could make many more scenarios, but you get the idea – there are a variety of ways of getting there that require some decent contributions and discipline, but these also aren’t dramatically huge amounts of savings for many readers of this blog.
Very rough rule of thumb – if you have £750k in your pension at age 68 (State Pension age) and invested moderately (5% growth rate), you’ll likely be close to using the full the lifetime allowance at age 75.
Benefits of exceeding the lifetime allowance
Before we talk about avoiding the 25% penalty, a quick reminder of the benefits we’ve enjoyed to get to the point of caring about the penalty at all:
- You expect to have more than £1,073,100 in your pension. At a 4% withdrawal rate, the amount under the lifetime allowance is almost £43k – after tax, that’s about £37k a year. That’s more than median household spending in the UK, and potentially a fairly comfortable retirement on its own. Add in State Pension and maybe Social Security, and you’re in pretty decent shape – the 25% penalty is hitting us on the gravy, not the foundation of a comfortable retirement.
- You’ve benefited from tax-deferred growth for the whole time your pension has been invested. No capital gains, dividend, or interest taxes along the way to slow down your compounding.
- Your whole pension balance is protected from inheritance tax (40%), including the amounts over the Lifetime Allowance.
- You may have benefited from salary sacrifice when you put the money in, saving you on National Insurance (12% or 2% tax, depending on your tax rate). You never have to pay that back.
- You may have benefited from more tax relief on your contributions than you’ll pay on your withdrawals, even with the 25% penalty. If you were in the effective 60% tax bracket (£100,000 to £125,140), you’ve saved 60% (62% with National Insurance using salary sacrifice) up front. Paying the 25% penalty plus income tax on withdrawals means that if you can keep your withdrawals and any other income under £100k a year, you’ll have an effective tax rate of 40% or 55% (25% penalty followed by 20% or 40% tax rate).
How to manage the Lifetime Allowance
There are a few options to avoid going over the Lifetime Allowance, or at least reduce the amount you go over. We’ll go into each of these in a little detail:
- Contribute less
- Grow less
- Withdraw aggressively
Option: Contribute Less
This is the most straightforward option – if you don’t want to go over the Lifetime Allowance, put less money in your pension. This can have a fairly dramatic effect early on, due to compounding.
Obviously, we still want to save and grow our money, so that means you’re putting your money somewhere else. The likely options include:
- Your spouse/partner’s pension or SIPP: probably the best option, if your spouse a) exists and b) has a lower amount in his or her pension.
- But, you can lose out on tax relief in some cases – for example, if you’re getting 62% tax relief (salary sacrifice, with your income in the £100k to £125,140 range), but your spouse is a basic rate (20%) taxpayer and doesn’t have access to salary sacrifice (so they’re still paying 12% national insurance), you’re effectively paying an “extra” 42% on tax that you wouldn’t have to if you used your pension. Even if you then have to pay the 25% penalty, you’re losing out. Same idea applies even in less extreme parts of the tax brackets.
- For the SIPP, we’re assuming it is actually a pension, protected by the US/UK tax treaty
- A Roth IRA: No tax on growth or withdrawals, no Lifetime Allowance or Required Minimum Distributions to worry about, but you do give up all the tax relief on contributions – that can be very big. Also, the limit is fairly low ($6,000) and you need to be eligible.
- A Stocks & Shares ISA: No UK tax on growth or withdrawals, no Lifetime Allowance or RMDs. But you give up tax relief on contributions and have to pay US tax on capital gains and dividends, plus have the hassle of using individual stocks. Fairly generous annual limit (£20,000 per person).
- A Lifetime ISA: Same as with S&S, but with the added bonus of effectively 20% UK tax relief (paid as a 25% bonus), balanced with locking your money up until age 60 unless you want to pay a penalty (small – 5% plus giving back the tax relief). Very low annual limit, though (£4,000, plus another £1,000 from the 25% bonus).
Aside from potentially your spouse’s pension, depending on individual circumstances, all of those options have significant drawbacks, especially for higher income/higher tax people. You’ll have to do your own calculations to see if it’s worth it.
Oddly enough, the case is clearest for basic rate taxpayers, especially without salary sacrifice – if you happen to already be on track to meet/exceed the lifetime allowance, I don’t see a compelling argument to save 20% now just to pay 25% + income tax (probably at least 20%) later. Even with salary sacrifice, saving 32% now to pay 25% + income tax later is pretty questionable.
Once you get into the 40% higher rate bracket, and especially if you think you can keep your taxes in the 20% basic rate bracket in retirement, you’re probably better off just paying the 25% penalty later on, or at least no worse off. But that depends on a lot of factors in your individual case!
Important Caveat: It should almost go without saying, but you should never reduce your contributions to the point that you start losing out on employer contributions. That’s free money, often a 100% or more instant return. No taxes or penalties are going to beat that.
- There’s a sub-caveat where you’re over both the annual allowance and lifetime allowance and you might actually have a tax + penalty rate of more than 100%. – you lose money by getting paid more. That’s a special situation (and a stupidly designed system) – I won’t go into it more here, things just get weird in that case.
Option: Grow Less
This is also a pretty simple option, but limited in its power. Basically, within your desired asset allocation, you choose to put assets that tend to grow more slowly in your pension – typically, this means bonds. We already want to have bonds in some kind of US & UK tax advantaged account anyway, so we don’t pay tax at income rates every year on the interest – this just means picking your pension over your IRA or 401k.
The more slowly your pension grows, the less chance of breaching the lifetime allowance, or at least you reduce the amount you go over. There’s no impact on your total growth rate – your portfolio allocation stays the same, just picking where to put bonds.
- This is an equally applicable option to Traditional 401(k) and IRA balances to manage Required Minimum Distributions, and, unless you have a large bond allocation and/or small tax-deferred balances, you probably can’t do both. I’ll talk about the tradeoffs between Lifetime Allowance vs RMDs in my next post.
Option: Withdraw Aggressively
This last one is a bit more complicated, but it’s potentially the most powerful, especially if you’ve already got a healthy balance in your pension and the modest reduction in growth by moving your bonds there won’t really move the needle.
The basic idea:
- Once you turn 55 (or 57, whenever you can get access to your pension), you start withdrawing from it quickly. You can use lump sums (UFPLS) or flexi-access drawdown and then take the income from the drawdown right away, either way does the same thing – you get 25% UK tax free, 75% taxable. Possibly 100% US taxable, but the foreign tax credits from the UK tax usually wipe that out – you will want to double check for your personal situation, though, because that’s not a certainty.
- Every time you withdraw, that withdrawal is a Benefit Crystallisation Event, so the amount you’ve withdrawn is tested against your lifetime allowance.
- Because you’ve completely removed that money from the pension, it will never be tested against the Lifetime Allowance again – you can reinvest it in an ISA or wherever, without worrying about the Lifetime Allowance or it’s 25% penalty, or you can spend it.
- With the current (2021) lifetime allowance and tax rates, it works out that you can withdraw the entire Lifetime Allowance without paying tax above 20%, when spread across age 55 to 75.
Let’s do a quick example. The situation:
- George is 55 and currently has £750,000 in his pension.
- George has stopped working and doesn’t expect to have any earned income. He doesn’t have any other taxable income either (any dividends, capital gains, and interest are below the UK allowances – we’ll just ignore them).
- At age 68, he’s eligible for State Pension and Social Security that total £12,570 a year (the Personal Allowance), so any income over that will be taxed starting at 20%
- Because George has made his asset allocation more conservative as he approached retirement and is preferentially putting bonds in his pension, with more equities elsewhere, we’ll assume only 4% average annual real growth of his pension.
- We’ll also assume the Lifetime Allowance is indexed to inflation, so we can just ignore inflation entirely.
Update 24Apr21: Reader John pointed out that I’d forgotten to include the 25% tax free amount, which effectively increases the withdrawal amount by a third without getting into the 40% tax rate. I’ve updated the example to reflect the tax free amounts – the concept is unchanged, but my math was wrong. Thanks John!
How does the aggressive withdrawal strategy work?
- Every year, George withdraws £57,000 from his pension (either UFPLS or Flexi-Access Drawdown with immediate withdrawal of the drawdown – doesn’t matter). He’ll change this to £47,400 at age 68, when he starts taking State Pension/Social Security. 25% of this is tax free, so his taxable income from the pension is £47,750 and £35,550, respectively.
- The taxable income (either £47,750 taxable withdrawal or £35,550 taxable withdrawal plus State Pension/Social Security) puts him near the top of the 20% basic rate bracket – George would rather not pay 40% if he can help it.
- Every time George withdraws that £47,4700 or £47,400, it’s tested against his Lifetime Allowance. Over the years from age 55 through 74, he uses £1,072,800 of the Lifetime Allowance (£1,073,100) – he has £300 of Lifetime Allowance left at age 75.
- When George turns 75, his remaining balance is tested against the Lifetime Allowance. Between 4% growth but the aggressive withdrawals, George has £21,816 in his pension when he turns 75.
- £21,816 is more than the £300 of remaining Lifetime Allowance, so George has to pay the 25% Lifetime Allowance penalty on the difference – 25% of £21,516 is £5,379, which comes out of his remaining balance, leaving him with £215,649 in his pension. He can use that for future income, pass it to his heirs without inheritance tax, donate to charity, etc.
- George also paid £193,602 in income tax on pension withdrawals along the way, for a total paid to HMRC from age 55 to 75 of £198,981.
What would have happened if George didn’t withdraw from his pension? Instead, maybe he was taking his income from an ISA, IRA, etc.
- George still starts with £750,000 in his pension at age 55, growing at 4% a year.
- He doesn’t touch it from age 55 to 75, so it grows to £1,643,342.
- At age 75, the balance is tested against the Lifetime Allowance. George hasn’t used any of his Lifetime Allowance, so it remains £1,073,100. £1,643,342 is more than £1,073,100, so George pays the 25% penalty on £570,242 – a tax bill of £142,560 taken out of his pension when he turns 75.
- That leaves George about £1.5M in his pension. It won’t be tested against the Lifetime Allowance again, and he can choose to take an income (subject to income tax but no more penalties), pass it to his heirs without inheritance tax, donate to charity, etc.
- George didn’t pay any income tax on his pension, but obviously needed to draw money from somewhere to fund his living from age 55 to 75, so may have paid tax on that.
At the end of the day, Withdrawal George paid a 25% penalty of £5,379, while Non-Withdrawal George paid £142,560. If Withdrawal George had been willing to pay some 40% tax on the income from his pension, he could have gotten the penalty to zero with more aggressive withdrawals early on, but obviously would have paid more in income tax. Paying 20% extra tax to avoid a 25% penalty, which will then reduce the taxable balance anyway, is basically a wash.
Personally, I think it often makes sense to fill up your 20% basic rate, but not to go into the 40% unless you actually need the income now and can’t get it from an tax free ISA or Roth IRA, or from a taxable account under the capital gains and dividends allowances. That approach also help with inheritance tax, keeping more in your pension and outside your taxable estate.
We didn’t mention US tax, because the UK foreign tax credits were enough to offset any concerns for Withdrawal George, even if his withdrawals were fully US taxable. Non-Withdrawal George hasn’t had any US income at all, so nothing to worry about.
To be honest, I don’t think there’s a clear right answer here – it depends on your whole financial picture. All else equal, it’s nice to avoid the 25% penalty over the Lifetime Allowance. But it’s not going to ruin you, because you’re already in pretty good shape if it’s even a concern. And a lot depends on the rest of your tax picture – trying to avoid the 25% penalty at the cost of more taxes elsewhere, or the cost of reduced growth and compounding, can really be counterproductive.
The only one that’s almost an easy win is making sure your bonds are in your Pension, or your US Traditional balance for RMD management. I can’t see any good argument for putting bonds in a Roth account, much less an ISA or taxable account.
In the next post, we add the complication of Required Minimum Distributions to the Lifetime Allowance picture. This is where it gets really fun.