Technical Note 3 – An unpleasant birthday surprise

Why simply reaching age 75 might result in an unexpected tax bill.

In this latest Technical Note we are looking at why the happy occasion of your 75th birthday might bring a nasty surprise. (I like to think of these notes as a collaborative exercise – I write, you read, and together we further our collective knowledge.) And that nasty surprise? – It’s a potential immediate 25% tax liability on part of your drawdown pension fund just for reaching your 75th birthday.
In my last note I looked at one of the most common Benefit Crystallisation Events. What I didn’t explain is why we have BCEs – they are there to test the value of a pension against the Lifetime Allowance (LTA).
The Lifetime Allowance sets a monetary limit on the value of pension benefits that you can build up in your lifetime. It is currently £1 million, though was as high as £1.8 million at one point. If at a BCE the relevant value exceeds the LTA a Lifetime Allowance Charge (a.k.a. tax) is applied. There are various means by which values higher than £1 million, or even higher than £1.8 million, could be shielded against the LTA Charge, but for the purposes of this note I will work with the current standard LTA of £1m.
Whenever there is a BCE the deemed value of that event uses up some of the LTA. In my last note I gave an example of a series of crystallisations that allowed for a total of £240,000 tax free cash to be withdrawn. Remembering that the tax free cash entitlement (in most cases) is 25% of the fund, that results in a total crystallisation value of £960,000. This is below the £1m Lifetime Allowance, so no LTA Charge would apply. The full pension fund has been crystallised so you might think you’ve got in under the wire, but I’m afraid not.
Right, time to concentrate – there are lots of numbers about to fly around. Of the 13 Benefit Crystallisation Events (yes, 13!) three relate to turning 75. One of these, BCE 5A – such imaginative naming conventions – tests the difference between the value of the opened pension fund on your 75th birthday and the value of the earlier BCEs; it captures the growth on already opened funds. So, that £960,000 crystallisation (let’s say it happened at age 65) left £720,000 in the fund after the tax free cash was taken. By the 75th birthday that £720,000 has grown to £1,200,000 (a not unfeasible 5.3% a year). BCE 5A tests this against the Lifetime Allowance by taking that £1.2m and deducting from it the values of the previous crystallisations, the £960,000 noted above, so the amount to be tested under BCE 5A is £240,000 (£1.2m less £960,000). However, £960,000 of the Lifetime Allowance has already been used, so there is only £40,000 of allowance left. Therefore, the BCE 5A test results in an ‘excess’ of £200,000. (This, believe it or not, is a simplified set of calculations – it gets even more complicated if the LTA changes between the various events, which is quite likely).
I need to take one step back now – when an LTA Charge arises before the age of 75, the rate used for the charge can be either 55% if the excess is taken out as a lump sum, or 25% if the excess is left in the pension and used to provide income (income tax at 40% results in a total of 55%, so there’s no difference). An LTA Excess Lump Sum is not available after age 75, so the effect of the LTA Charge at BCE 5A is an immediate tax charge of 25% on the excess, £50,000 of tax in this example. Effectively then, that pension fund worth £1,200,000 one day before your 75th birthday, becomes £1,150,000 on your 75th birthday – a rather unpleasant birthday surprise.
So what can you do to avoid this tax charge? The only real answer is to take taxable income from the opened fund so that the value does not increase above the £1 million limit. But as I say, that is taxed income, so one way or the other the Exchequer wins. Alternatively, I suppose, you could leave it all in cash achieving no growth to avoid the tax, but which is better? No growth at all or three-quarters of some growth?
This 25% ‘birthday tax’ may be considered iniquitous, but we should not lose sight of the fact that pensions continue to offer very good tax benefits. Okay, 25% of the excess growth is lost, but age 75 is the last time a pension is tested (except in a few rare cases). The funds continue to grow in a tax-advantaged environment and, if not withdrawn, are also outside your estate for Inheritance Tax; furthermore, on death before the age of 75, whoever you have nominated to receive your pension fund will not be taxed at all on what they withdraw from it. On death after age 75 your nominees will only be taxed at their marginal rate for income tax on what they withdraw.
In these last two notes I’ve barely touched on the foggy world of pension crystallisations, but these are two common situations we come across. Next time, I will steer clear of pensions and will look at the – perhaps murkier – world of insurance bond taxation.

Philip Chandler APFS, CFPTM, Chartered MCSI

Chair of Aspinalls Technical and Investment Committee