Pension LTA not always 'hard stop' limit

11 May 2022

Tax Year 2021/22 is set to be a record year - the highest ever recorded for investing in Venture Capital Trusts (VCT). Total capital raised for investing in shares or securities, including loans of at least five years duration, in unquoted companies and those whose shares are traded on AIM is on target to reach £900m before the end of the current tax year.

VCTs, Enterprise Investment Schemes (EIS) and Seed Enterprise Investment Schemes (SEIS) have all benefited from significantly increased investment inflows over the last couple of years. But why?

There are two principal reasons why this is happening. The first is linked to the pension lifetime allowance (LTA) which was frozen last year until April 2026 at £1,073,100. The second may well be linked with the glut of the largest and wealthiest tranche of the UK population - the Baby Boomer Generation aged 59 to 76 this year moving into retirement.

According to Dunstan Thomas' recently published study of Baby Boomers, 19% of this generation have retirement savings in occupational defined contribution (DC) plans. A further 25% have SIPPs and other non-workplace DC pension plans. More importantly, 48% of them have the more generous occupational defined benefit (DB) schemes which are much more likely to have accumulated values in excess of the current LTA. This means that they could incur a tax charge of between 25 and 55% if and when they begin taking money out of their pension, or if they transfer that pension overseas or reach the age of 75.

To avoid breaching the LTA limit and incurring this undesirable and probably unexpected tax penalty, many are opting for diverting savings they would normally place in their pension into other tax-efficient investment vehicles outside their pensions, including those VCTs, EIS and SEISs.

Enticing

After all the tax incentives are enticing. Holders of VCTs can claim up to 30% of upfront income tax relief on the amount you invest, provided you keep your VCT shares for at least five years. While EISs, which invest in businesses with no more than 250 full-time employees and gross assets of less than £15m, also offer income tax relief of 30% of the value of their investment.

Meanwhile, SEISs, which invest in start-ups which are less than two years old and have assets worth less than £200,000, offer 50% income tax relief on the amount invested. Both EISs and SEISs can be sheltered from inheritance tax (IHT), so no wonder they are gaining ground amongst wealthier Boomers now planning their decumulation journeys.

However, all of these investments share something else in common - they are very risky. They offer investments in small to medium-sized businesses, many of which will not stay the course.

According to business funding network Fundsquire, 77 new companies are founded every hour. However, 60% of them fail within the first three years which is before you get an exit opportunity under VCT or EIS rules. They are marketed as investments for sophisticated investors only and for good reason. It's also worth considering that all pensions-held assets are considered as outside of your estate, so don't attract IHT either.

Lifetime allowance not limit

Crucially, remember the lifetime allowance is just that, an ‘allowance' not a limit. So, a different kettle of fish than ISAs, where if you inadvertently pay in more than the £20,000 ISA limit, your money is sent back to you!

For many Boomers set to breach their LTA before they start decumulating, it's not the end of the world.

It may even be sensible to carry on with further contributions. Just take steps to manage the financial impact of this future tax liability. We have decided to explore a few methods of doing so.

Don't underestimate value of employer contributions

Continuing to pay into a workplace pension scheme, even if you have exceeded the LTA may still make sense in many schemes which offer no alternative to receiving often generous employer contributions. Many workplace pension schemes today match the employee contributions and even the less generous auto-enrolment workplace pension schemes today mandate that a minimum of 3% of qualifying earnings is added by the employer to the scheme member's 5%. If you come out of the scheme, you will invariably forfeit that employer contribution at a time when it is likely to be at its highest - just prior to retirement.

Options to reduce other tax charges

Furthermore, employee contributions can be highly tax-efficient if made via a salary sacrifice scheme. This means that pension contributions from your employer increase, except that they are really your own contributions, because your salary is proportionately reduced. However, the payments count as employer contributions, rather than employee contributions. The difference is that National Insurance (NI) contributions are avoided. Your employer saves on NI too and in some cases is prepared to add that gain to your pension. Salary sacrifice just got even more interesting in April 2022 as both employer and employee NI rates went up by 1.25% each, so there's a further 2.5% that can be saved via salary sacrifice.

And your take-home pay as you approach retirement needn't be any lower than if you were making the pension contributions yourself as employee contributions because you choose how much salary to sacrifice.

Bonus sacrifice is a timely opportunity for workers that receive an additional bonus towards the end of the tax year. It works like salary sacrifice but because it typically happens at the end of the tax year, it's especially useful for managing end of tax year planning issues.

Higher tax relief on contributions

Because of the withdrawal of the Personal Allowance at a rate of 50p for every £1 of adjusted net income between £100,000 and £125,140, the effective tax rate in this band is actually 60%. Personal contributions to a pension reduce adjusted net income, so if they are receiving an effective 60% rate of tax relief that may substantially offset the damage of any future LTA charge on decumulation.

Selective movement of assets outside pension wrapper

For those that have crept over the LTA close to retirement, there is also scope to be selective as to the timing of withdrawals and benefit crystallisation events. In addition, for partial withdrawals, there is scope to be selective as to which assets to bring through the tax net and when to do that.

For example, consider the relative performance of two tracker ETFs that might be in many clients' portfolios today. The first tracks the FTSE-100, while the second tracks the FTSE-250 index. What we have seen in 2022, as Covid's ravages are supplanted by inflation, the cost of living crisis and the war in Ukraine, is that FTSE-250 trackers have fallen a good deal more than FTSE-100 trackers.

So, now might be a suitable time to sell that FTSE-250 tracker held inside your SIPP, withdraw the money and repurchase the same tracker in a GIA or ISA. So, the moral here is poorly performing assets that you expect to recover in time can be moved out of a pension wrapper and repurchased elsewhere (while prices and charges are still relatively low) - simultaneously reducing any potential LTA tax charge liability. Whilst falling markets are never welcome, they can provide brief opportunities for LTA-challenged savers to move money before prices bounce back.

In the early years of retirement, many clients may work in close cooperation with their adviser using phased withdrawals and drip-feed drawdown to meet income needs in a tax-efficient manner. Advisers will be able to take LTA issues into consideration at the same time to help clients make the best use of crystallisation flexibilities available on their platform.

In conclusion, don't assume that exceeding LTA must be avoided at all costs. And it rarely makes sense to put future retirement savings at serious risk outside a pension wrapper just because you've maxed out the pension LTA.

Instead, consider maximising use of tax reliefs on pension contributions and optimising employer contributions while you still can. Nearer retirement, aim to reduce the impact and size of any potential LTA tax charge by timing all vestings carefully, dovetailing LTA considerations into the mix of crystallisation and withdrawal options.

by Adrian Boulding, Director of Retirement Strategy at Dunstan Thomas.