Individuals considering the transfer of large UK pensions to a Qualifying Recognised Overseas Pension Scheme QROPS should be aware of the impact of the Lifetime Allowance (LTA) on their pension savings. The option of applying for LTA protection should also be examined.
QROPS, Lifetime Allowance and Benefit Crystallisation
A transfer from a UK registered pension scheme to a QROPS is considered to be a Benefit Crystallisation Event (BCE). When an individual crystallises their benefits to take a pension commencement lump sum or to facilitate the withdrawal of income from their pension capital, there is a test on the value of the crystallised savings against their LTA. Once the value of the total UK pensions exceeds that limit, an individual would be subject to a tax charge of up to 55% on any BCE upon retirement or death. The transfer of your UK pension to a QROPS would arrest the growth on your LTA at today’s value.
Over recent years we have witnessed a steady erosion of the allowance threshold from £1.8m in the 2010/11 tax year. The LTA was lowered to £1.5m for the 2013/14 tax year, £1.25m for 2014/15 and then reduced to £1m in April 2016.
The current LTA of £1,075,100 is the maximum amount of pension saving you can build up over your life that benefit’s from tax relief. If you have pension savings worth more than the lifetime allowance you will have to pay a tax charge on the excess.
The relevance of QROPS and the Lifetime Allowance to you
Individuals living abroad who wish to access their pension savings in the current tax year may gain over the longer term from the transfer of their UK pension into a QROPS and therein the crystallisation of benefits. The net result could be:
- An increase in the available pension commencement lump sum that is tax-free from any future crystallisation
- Reduced likelihood of suffering an LTA tax charge on the future value of their pension fund whenever they draw on those untouched pension savings
Expats who have worked for some time in the UK in senior positions tend to have reasonably large pension pots. Many who are nearing retirement will already have fund values of circa £1m; younger executives may also be on the way to securing such a figure. Those with pension pots close to the LTA limit can choose to use a QROPS for the following tax planning purposes:
- By transferring to a QROPS the Lifetime Allowance is suspended at that point in time.
- Whatever value your pots have reached will therein be registered with HMRC, and will not increase from that point unless and until you become UK resident again and resume contributions to a UK pension.
By transferring to a QROPS and keeping your UK pot below the £1,075,100 LTA limit, your total saving potential is almost unlimited!
How to claim your LTA Protection at 2016 levels
The current £1,075,100 LTA limit has ‘real teeth’ and will catch a lot of pensioners now and into the future. Tax will be payable at 25% of the excess in the case of benefits drawn as a taxable income stream, or 55% for lump sum benefits. However, there are ways to either reduce or avoid this tax. LTA Protection is available to those who have made no further contributions or participation in pension plans from the 6th of April 2016.
Fixed Protection 2016 (FP2016)
Provided there are no further contributions to Defined Contribution (DC) pension schemes, those with total pensions of more than £1,075,100 can apply for FP2016. In so doing their assets will be protected at the 2016 limit of £1.25m.
The same applies for those with Defined Benefit (DB) plans, excluding any future inflation increase. DB benefits are generally calculated at 20 times the annual pension entitlement as at 6th April 2016. The calculation is based on the ‘full pension’ before any reduction for lump-sum benefits.
Individual Protection 2016 (IP2016)
IP2016 is available to anyone whose total DC pension entitlement as of 6th April 2016 is more than £1m with a cap at £1.25m. The difference between IP2016 and FP2016 is that it is still possible to contribute to pensions after you claim protection. However, those considering this type of option have to be aware that any accrual above £1.25m will suffer tax as above.
Similar rules apply for DB pensions. Individuals with full pension benefits of over £1,075,100 can file for protection. Members can continue contributing to their fund; however, total pension values have a cap at £1.25m.
How to apply
The UK government’s ‘department for work and pensions’ website offers useful information on how to apply for LTA Protection: LTA reduction
QROPS and Lifetime Allowance Protection: Tax planning opportunities
Assuming LTA protection has been applied for, and your pension entitlement is still higher than £1.25m, a transfer to a Recognised Overseas Pension Scheme (ROPS) will have a 25% tax on any excess. In many cases, tax on lump sums in your chosen country of retirement may be considerably less (or even zero in some cases) than the punitive 55% applied to UK pensions. As such, whether you have to pay tax or not, it is best to commute the whole pot as a drawdown income stream, pay the 25% on the excess, then withdraw the Pension Commencement Lump Sum (PCLS) when in situ.
In other cases where the total protected pension pot is within the £1.25m limit it would usually be better to take the lump sum while still UK tax resident, then draw down the income stream after transfer to a QROPS / ROPS.
QROPS members that resume/take up UK tax residency can receive a Pension Commencement Lump Sum (PCLS) at the level of 25% which will not be subject to UK tax. However, once the member commences income drawdown, he forfeits all rights in the future to PCLS, irrespective of where he is tax resident.
The various QROPS/ROPS jurisdictions have different rules for drawdown. It is, therefore, essential to choose the right one for your needs. Malta is currently the preferred choice within the EU, as it offers pension freedoms similar to those available in the UK.
Potential banana skins
UK rules regarding DB schemes are a little out of date in terms of the 20 times multiplier. Most DB schemes’ Cash Equivalent Transfer Values (CETV) are calculated at 30 times or more. This means that the actual CETV applied at retirement or transfer may be considerably more than expected. If an individual is still a long way from retirement, he/she should take this into account.
There is a need to be careful when comparing benefits from DB schemes with QROPS or DC transfers. Official Critical Yield (CY) calculations should have been updated following the pension freedoms legislation of 2015. The old rules still assume that an annuity is the only DC option; this has made CY assumptions almost irrelevant. In short, a CY rate is the investment yield required to equal any DB pension income prediction. As such, the analysis may suggest you need to achieve a 6% rate of investment return to equal your DB pension. The problem with such a calculation is that there is an assumption that individuals will withdraw a low-rate annuity (of perhaps around 4% p.a.). In practice, however, and as a result of new UK pension freedoms, a lot of retirees would seek to draw down more than an annuity would permit, thus invalidating any CY calculation.
Moreover, as there is now no requirement to take an annuity, DC schemes have become more attractive in terms of passing wealth down through generations. Previously, a surviving spouse would receive a pension at 50% of the value; the remainder would be forfeit. In the new era, this is no longer the case.
LTA Protection is a relatively complex area of financial planning that requires scrutiny. If unsure about limits and how best to approach this issue, we recommend that you seek professional advice.
Pension funds are easy targets for governments wishing to raise revenue; we have seen such ‘raids’ under both Conservative and Labour governments in the past. The current trend suggests that the government will lower the lifetime allowance limit below the present threshold at some stage. There is always a window of opportunity for pension planning!
For further information about QROPS and the Lifetime Allowance, please download our free QROPS Guide