The lifetime allowance limits the total tax privileged pension benefits you can build up from all your pension plans, excluding the State Pension. If your pension benefits exceed the lifetime allowance total, which has changed over the years then you will feel the sting of a hefty tax charge, unless you have existing pension protection in place. In the 2018/19 tax year the lifetime allowance stands at £1.03 million and will increase by inflation to £1.055 million on 6th April 2019. If you think you could be affected by the LTA charge, there may be ways in which you can protect yourself and reduce the amount of tax you pay. One way is to consider utilising your NHS lump sum.
The tax charge you will face depends on how you intend to take that part of your pension which exceeds the lifetime allowance.
The lifetime allowance charge is:
* 55% if you’re taking the excess as a lump sum; or
* 25% of the capital value where you take it as a taxable pension income
The NHS Pension Scheme does not offer you a choice, any excess must be taken as income and is charged at 25%. The charge is deducted from your pension and this reduced pension is payable for life. The exception is where your standard lump sum exceeds 25% of the lifetime allowance, in which case the excess is charged at 55%. If you have lifetime allowance protection this may afford you an additional tax free lump sum.
So, how does it all work?
Working out your lifetime allowance tax charge may seem daunting at first, as there are calculations involved. To make it easier to digest however, we’ve broken it down with an example, based on the 1995 Section.
If your pension at retirement is £50,000, you’d receive an automatic lump sum of £150,000. The below calculation will help you to work out the capital value of your NHS pension.
Pension (£50,000) x 20 + lump sum (£150,000) = £1,150,000
Excess over the LTA (£1,150,000 – £1,030,000) = £120,000
LTA charge on pension (25% X £120,000) = £30,000
This is deducted from your NHS pension based on an age related factor. Any reduction is permanent and does not affect your lump sum.
Using your lump sum to reduce the LTA charge
On 1st April 2008, the NHS Pension Scheme changed the rules to allow individuals to take a bigger lump sum by forgoing part of their pension, which is known as commutation. For every £1 of taxable pension, this provides £12 of tax-free lump sum..
Continuing with the above example.
Say you decided to commute (exchange) £5,000 of your £50,000 pension, this would reduce your pension to £45,000. As a result, you’d receive an extra £60,000 as a tax-free lump sum (£12 for every £1 of taxable pension given up).
Your total capital value would then be:
Pension (£45,000) x 20 + lump sum (£150,000 + £60,000) = £1,110,000
Excess over the LTA (£1,110,000 – £1,030,000) = £80,000
LTA charge on pension (25% X £80,000) = £20,000
This means your potential tax saving would be £10,000.
As this is deducted from pension the actual tax saving will be determined by the number of years you draw your pension.
When giving up part of your pension for additional tax-free lump sum, however, it’s important to remember that the maximum tax free lump sum you can take is the lower of:
• 25% of the available LTA; or
• Maximum lump sum permitted under scheme rules …
… In the above example, the maximum permitted lump sum is approx. 5.36 x pension or £268,000
An added bonus for all members is that payments to surviving spouses or partners and children in the unfortunate event of death are based on the original pension amount, as opposed to the reduced amount, even if you’ve taken out a bigger lump sum previously. Going back to the example, this would be based on the original £50,000 pension not the reduced £45,000 pension.
Don’t let the tax tail wag the dog.
Getting caught up on how you can reduce your tax without thinking of the bigger picture and your retirement can have long-term consequences. Although it may be tempting to prioritise tax mitigation, it’s much more important to focus on the income you need to live on, so you can maintain your standard of living while in retirement. This is something we support as experienced financial advisers for medical professionals, as we’re fully aware of the long-term consequences this can have. It’s also important to remember that there are other ways to protect yourself from the lifetime allowance tax charge, so if you fear you could be affected, we’d advise weighing up all your options beforehand.
The Financial Conduct Authority does not regulate Tax Planning.
The contents of this article are for information purposes only and do not constitute individual advice.