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Tax penalties on pensions and how to avoid them

Author: Jason Porter, Blevins Franks

Published: 09 Sep 2020

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UK nationals risk up to 55% taxation if pension funds exceed the lifetime allowance on any one of 13 Benefit Crystallisation Events (BCEs) and 25% on some overseas pension transfers. But there are steps to take to limit exposure, writes Jason Porter, director of specialist expatriate tax and wealth management firm Blevins Franks.

How much are the pensions worth? The answer is not always clear, especially if clients have accumulated several different types of pension over their lifetime.

While it may seem beneficial to hold as much as possible – the bigger the better to finance retirement – having too much in UK pensions can actually expose funds to eyewatering tax penalties. And, as with any financial arrangement, the way pension benefits are structured and accessed can have a significant impact on the tax bill.

Where in addition, the UK national is an expatriate, it is sensible to explore the options and how to protect pensions from unnecessary taxation, especially as full Brexit draws near.

The UK’s lifetime allowance (LTA)

The LTA is the maximum clients can hold in combined UK pension benefits before extra tax penalties of 25% or 55% apply. The current limit – £1,073,100 – may seem very high, but many people are closer to it than they realise.

All pension benefits (excluding the State Pension) count towards the LTA, often including decades of contributions, compound interest, investment growth and tax relief.

For defined benefit (‘final salary’) pension schemes, the usual measure of value is 20x the annual income due. Generally, this means those with defined benefit pensions worth £53,655+ a year may already be in excess of the LTA today.

What are the LTA penalties?

Once the allowance is breached, penalties are payable whenever funds are accessed or passed on to heirs (or one of the other BCEs). Rates are 55% for lump sums and 25% for income and transfers, with tax also payable on the subsequent net amount the member receives, at their marginal rates. Without effective planning, this can clearly have costly tax implications for them and their heirs.

Calculating how much of the allowance has been used is not always straightforward, especially for defined benefit pensions, so calculations should be requested from the scheme provider, prior to any action being taken. HM Revenue & Customs (HMRC) will automatically test where they sit within the allowance when they turn 75, whenever they take money out, and finally on death. 

How to protect pensions from the LTA

It is possible to secure a higher limit by applying for LTA ‘protection’ from HMRC, but take care as strict conditions can apply.

Expatriates are able to transfer one or more UK pensions to a Qualifying Recognised Overseas Pension Scheme (QROPS). Although they would pay 25% on anything transferred over the LTA, once in a QROPS, funds are immune from future LTA penalties. A QROPS can also provide ongoing tax efficiency, income and currency flexibility, and certain estate planning advantages. However, similar benefits could be achieved by reinvesting cash from UK pensions into alternative locally-compliant arrangements, so personalised advice is important.

The overseas transfer charge (OTC)

When transferring UK pensions into a QROPS, LTA charges will only apply if total benefits are over £1,073,100 – but beware another potential tax trap. If clients are EU-resident, their QROPS must be based within the EU/EEA or they would instead lose 25% of funds to the UK’s ‘overseas transfer charge’. It is vital clients take specialist advice to navigate suitable options and avoid this unnecessary tax.

Note that the 25% LTA tax applies to funds over the limit only, whereas the 25% overseas transfer charge is made against the entire amount. 

After the Brexit transition period ends in December, the UK has scope to extend the OTC to include all EU/EEA transfers with a very simple adjustment to the current legislation. As such, there may be limited time to transfer without losing a quarter to UK taxation.

What if they are already over the lifetime allowance?

Excess funds transferred to a QROPS trigger an immediate 25% LTA tax bill, but clients could subsequently access their money – however they wished and in their preferred currency – without further UK taxation. Funds would also be free to grow without incurring higher penalties, and more flexibility and tax efficiency could be unlocked when passing pensions on to chosen heirs.

If they transferred to a UK scheme instead, like a Self-Invested Personal Pension (SIPP), they could do so tax-free but would remain liable to LTA penalties whenever they take benefits or pass them to heirs. 

Reviewing pension options

Even if pension benefits are within the LTA or clients are not ready to access them, it is sensible to review their situation in the context of their wider tax, wealth and estate planning goals.

Pension transfers can take several months – and the rules could change post-Brexit – so explore options sooner rather than later, especially if they are close to the limit. While pension funds are free to grow, the lifetime allowance is only set to increase with inflation each year so they could potentially avoid unnecessary taxation by taking steps now. 

About the author

Jason Porter is a Director of Blevins Franks, which provides international tax and wealth management advice to Britons living in France, Spain, Portugal, Cyprus, Malta and the UK, through 22 offices.

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