Now that Novia offers in-specie Additional Permitted Subscriptions it’s the perfect time to review the changes to the rules around ISA inheritance.
The Lifetime Allowance (LTA), currently set at £1,055,000, is the maximum amount of pension benefits that a person can crystallise during their lifetime before the tax incentives of a pension scheme become significantly degraded. This article takes you through some of the calculations that are used by pension scheme administrators to test against LTA, and may provide some food for thought if you're considering the options for managing large pension pots into retirement.
Prior to 2015, ISAs belonging to deceased investors had to go through a confusing and detailed process in order to be distributed as part of the estate. The tax benefits afforded by ISAs were only available to investors during their lifetime, so at the date of death the ISA would be dismantled. Providers had to ‘unwrap’ the investments so that they were exposed to tax. In most cases the contents were then inherited by a surviving partner, who would become liable for capital gains tax and income tax since the date of death.
Time delays were an issue. Sometimes death notification would not reach the ISA manager for a month or two, during which time tax free interest and distributions will have been applied to the account. Rather than unpick those transactions, ISA managers were supposed to give the beneficiary a detailed transaction history so that they could go through it with a fine-toothed comb to identify and pay any tax due. Clearly this was an unrealistic expectation and something that would require professional help.
In April 2015 Additional Permitted Subscriptions (APS) were introduced. This enabled a surviving spouse or civil partner who was inheriting the ISA to transfer the contents to their own ISA. In theory it solved the problem of unexpected and unwelcome tax liabilities, but in practice it only went half-way to achieving this. For a start, the APS limit was set at the ISA value at the date of death. That meant that any growth during the administration of the estate, which in the UK means typically 6-9 months, would not be eligible for APS and would instead end up as a taxable amount in the hands of the spouse. Also, in spite of the changes, the rule about an ISA only being valid during an investor’s lifetime was still in place, so the ISA still needed to be unwrapped and exposed to tax for the 6-9 months. So progress was made, yet the fine-toothed comb would still get an airing.
It wasn’t until April 2018 that the full package was delivered. An ISA can remain ‘wrapped’ during the administration of an estate. What’s more, the value of the APS can be extended if there is growth during that time. Whilst the in-specie option for inheriting assets was technically possible from 2015, the 2018 change made it widely feasible. Following some internal development, Novia is now pleased to offer in-specie APS so that the investments don’t need to come out of the market.
The following illustrations assume a continuously growing fund value (both inside and outside the ISA), and an immediate subscription via APS:
Some APS facts:
APS is an allowance in addition to the usual £20k. It’s recorded by the ISA manager as previous years’ subscriptions.
The Lifetime Allowance (LTA), currently set at £1,055,000, is the maximum amount of pension benefits that a person can crystallise during their lifetime before the tax incentives of a pension scheme become significantly degraded. This article takes you through some of the calculations that are used by pension scheme administrators to test against LTA, and may provide some food for thought for those considering the options for managing large pension pots into retirement.
The Lifetime Allowance was introduced in 2006 as a way to limit the pension benefits enjoyed by wealthy savers. It was part of the ‘A-day’ pension simplification changes; a decade later, many people were calling for the government to complete the process of simplification… by scrapping it. Given that there was already an annual allowance for money coming into a pension, they argued, why did we need another complicated limit for money coming out?
Introduced at £1.5m, the allowance has oscillated as various chancellors have tinkered with it. Only recently in 2017 did the threshold settle. The government announced an intention that the LTA would rise in line with inflation (the Consumer Prices Index), and, so far, that’s what’s played out.
LTA and Defined Benefits
Controlling pension savings in a DB scheme can be challenging. Benefit accrual happens as a result of pensionable service, and so a client increases their pension savings not just by making contributions but fundamentally by turning up to work. This has been an issue in the NHS scheme in recent years, where senior surgeons on higher salaries have reportedly been refusing extra shifts in order to prevent their pension benefits accruing beyond the relevant threshold.
The Lifetime Allowance test in a final salary scheme is, in contrast to pretty much every other DB calculation, simple. The test occurs at the point of retirement, when the annual pension is multiplied by 20 to ascertain how much LTA is being utilised. For example, a person retiring in a 1/60th accrual scheme, having reached a final salary of £120,000 over 30 years of pensionable service, would have a pension at retirement of £60,000. Assuming no tax free lump sum is taken, the LTA utilised would be (£60,000 x 20 =) £1.2m, which would exceed the current threshold and trigger a Lifetime Allowance Charge. The scheme would pay the charge to HMRC and reduce the annual pension of the retiree in order to claw it back.
For those advisers still brave enough to deal with transfers out of DB schemes, it’s worth noting that the multiple of 20 is comparatively low compared to some of the transfer values offered in recent years. If a transfer value is 30 times the annual pension, a client who is set to come in under the threshold in their DB scheme could find themselves way beyond it following a transfer out.
Exceeding the LTA in a money purchase scheme
It’s easier to control pension inputs in a money purchase scheme such as a SIPP, but investment growth can still elevate a client’s fund beyond the Lifetime Allowance. Yes, the LTA is increasing with inflation - but if a client has aspirations for their pension pot to outperform inflation, any significant exposure to the stock markets could see it accelerate past CPI and into chargeable territory.
For many the crunch question will be this: should a wealthy client continue to save in excess of the LTA and pay the associated charges, or should they attempt to stay under the limit? Before deciding on an approach, it’s wise to look at the possible strategies in the light of the client’s personal circumstances.
The LTA charge is set at 55% or 25%, depending on how the LTA excess is taken. If the excess over the threshold is being pulled out of the pension scheme as a lump sum, then the 55% rate applies. If however the excess is being retained in the pension scheme for withdrawal at a future date, then a lower rate of 25% applies in recognition of the eventual income tax hit when the money is withdrawn as income. Sometimes there is no option (for example, at age 75 the excess will always be a retained amount) but in many cases there is a choice to be made. For example, if the client is taking a Pension Commencement Lump Sum and designating the remainder to drawdown, then the excess fund at the crystallisation event can be taken either way.
LTA will get you in the end
Every time you take benefits there’s a test against the Lifetime Allowance. But what if you don’t take benefits? Keep your pension pot as an inheritance, and live off other savings?
There are two LTA tests lurking in every client’s future: one upon reaching age 75, or one upon death prior to reaching that age. Given that life expectancy is in the early eighties, reaching age 75 is quite likely. Either way, it is inevitable that every client will be subject to one of these crystallisation events. If they do pass away prior to age 75 then the death benefits are tax free, but the beneficiary becomes liable for calculating and paying any LTA charge.
At the time of distributing the death benefits, the administrator will likely present a beneficiary with a decision point: take a lump sum, or take a pension. If the fund they’re inheriting breaches the Lifetime Allowance, they are likely to choose the pension. This retains the LTA excess within the scheme, and so carries the lower LTA charge of 25%. Because death benefits from under 75s are generally tax free, there would be no additional income tax to pay upon withdrawal; and, because of the flexibilities introduced in 2015, they can potentially withdraw it all immediately. Based on the current rules, a beneficiary who is tempted to take a death benefit lump sum can save 30% on any LTA charge by instead designating to drawdown and taking a full withdrawal. That said, an adviser may naturally be minded to steer them towards keeping the money in the drawdown in order to enjoy further tax free growth and potentially tax free onward inheritance with no further LTA tests for future beneficiaries.
For wealthy clients in good health and with a view of living beyond age 75, there are opportunities to plan in preparation for the age 75 event. It’s possible to manage fund growth by winding back exposure to stock markets in favour of fixed interest investments. However, some advisers may be reluctant to start de-risking a portfolio too soon and may keep their foot on the gas for longer, in the knowledge that income withdrawals do not trigger LTA tests.
To explain this, here’s how a SIPP is considered for lifetime allowance purposes at age 75:
At 75, any untouched accrual moneys will be tested against the LTA as ‘unused funds’. However, drawdown moneys will have already been tested at the time of the benefit crystallisation event that designated them into drawdown. At age 75 it’s only the growth on the drawdown that gets tested. If the eventual drawdown value is lower than the value originally designated, then there will be no additional LTA utilised. A client of pensionable age and with a fund value approaching the LTA might therefore decide to crystallise everything before they cross the LTA threshold and onward-manage the fund value up to age 75 via a series of small income withdrawals. The attractiveness of this option would depend, amongst other things, on the level of income tax they are likely to pay on those withdrawals.
If a client makes a decision to crystallise prior to age 75 and their pension savings are beyond the Lifetime Allowance, the first thing they can expect to notice is that their Pension Commencement Lump Sum (PCLS) will be less than the usual 25% of the fund value. PLCS is limited to 25% of the remaining LTA - another way for the government to limit the pension tax benefits for high earners.
The next thing they’ll come across is the choice of 55% or 25% LTA charge. Higher rate tax payers may do some quick arithmetic at this point and opt for the 55%. However, designating the excess to drawdown gives high earners the opportunity to defer that income tax to later in life – perhaps in a few years when they’ll no longer be earning and their pension will be their primary source of income. That brings into play the personal allowance and the basic rate tax band. If these are utilised in full, based on current rates, 50k (gross) could be withdrawn every year at an effective income tax rate of 15%.
In money purchase pensions, the LTA test at age 75 is the ultimate and final test. If your client is approaching or exceeding the Lifetime Allowance the eventual impact at age 75 can be managed to an extent. Further opportunities will arise once they are of pensionable age and able to utilise income withdrawals, and the interactions between LTA charge and income tax will be relevant.