No tax-free cash is available from the excess, which instead incurs a 25 per cent tax charge when accessed (rising to 55 per cent if encashed as a lump sum).
In more simple terms, it could be viewed that any tax-free cash entitlement becomes payable to the government on the funds that exceed the lifetime allowance.
Therefore, to avoid the lifetime allowance charge, it may be tempting to take tax free cash before the limit is reached and let this money grow outside the pension fund.
Thinking ahead about tax
However, this course of action is not always as good an idea as it might first seem.
For example, taking £268,275 (25 per cent) in tax free cash from a pension fund of £1,073,100 a year may prevent a lifetime allowance tax charge from occurring.
However, these funds will no longer benefit from growing in a tax-efficient pension wrapper and would now be part of the estate for inheritance tax purposes.
A 40 per cent (£107,310) inheritance tax charge on £268,275 will be far more expensive than paying a 25 per cent lifetime allowance charge on any future investment growth within the pension.
Furthermore, this amount would far exceed the £20,000 annual Isa limit, meaning any investment returns outside the pension may become subject to capital gains tax or income tax on dividends.
Finally, to fully avoid a lifetime allowance charge, additional taxable income would need to be taken from the pension, as any growth on a drawdown fund is tested against the lifetime allowance for a second time once age 75 is reached.
On the other hand, if the pension fund were to be left untouched, and it grew at 4 per cent a year until April 2026, the lifetime allowance charge would equate to 25 per cent of the growth – in other words, 1 per cent a year or £58,122.56 after five years.
Although this is a significant sum, the charge would only be payable once funds were fully accessed or age 75 was reached.
This charge needs to be weighed up against any potential tax charges if the growth had occurred outside the pension. Tac charges include inheritance tax, capital gains tax and income tax on dividends.
Tax treatment on death
A further factor to consider here is the tax treatment on death.
On death before age 75, an untouched pension fund within the deceased’s lifetime allowance can be paid to a beneficiary tax free, with a 25 per cent lifetime allowance charge due on any excess.
The lifetime allowance test can potentially be avoided by delaying designation of the fund for two years after the member’s death. Doing this would instead make the fund taxable as the beneficiary’s income.
