Several years ago, Kirk left his job as a senior manager in a high street bank and began to focus on his hobby of selling TV sci-fi memorabilia online. Although this was a leap into uncharted territory, he has been making sizeable profits now for several years.
Kirk has a defined benefit (DB) pension scheme from his time at the bank, and he started taking benefits from it when he left employment. This used up almost all of his lifetime allowance (LTA).
His DB pension is enough to cover his day-to-day expenditure. He is now thinking about what to do with the money he is making from his business.
He has two children who are basic-rate taxpayers and five young grandchildren. Kirk himself is currently a higher-rate taxpayer.
He knows he is very close to the LTA thanks to his DB scheme. But he has discovered it may still be worth contributing the funds to a pension.
If Kirk puts the funds into a pension, he will eventually pay an LTA charge of 25% on those funds. This is unavoidable and will happen either when he takes benefits, when he turns 75 or when he dies.
He will also pay income tax on any withdrawals he makes. However, he will still be able to take his 25% tax-free lump sum.
The next generation
As Kirk is a higher-rate taxpayer, he will get tax relief of up to 40% on the contributions.
If he comes to take income from his pension at a later point, he will have paid a 25% LTA tax charge. If he is a basic-rate taxpayer at this point, the effective overall rate of tax for any income he withdraws, however, is also 40%.
Crunching the data, this means he will have gained 40% on the way in and he is set to lose 40% on the way out. This does not seem too bad on paper, particularly as his pension will benefit from tax-free compound growth.
He could achieve a similar effect with an ISA. The advantage with a pension, however, is it will not form part of his estate. This means it will not be subject to inheritance tax when he dies.
Talking of death benefits, Kirk is also conscious he might not need to withdraw any income from his pension at all. Instead, he could leave it to his children and grandchildren when he passes away.
If Kirk dies before he turns 75, there will be a 25% tax charge when the death benefits are converted to dependants’ or nominees’ drawdown. However, the recipients would be able to withdraw the funds tax-free.
Live long and prosper
If Kirk lives to 75, there will be a 25% LTA tax charge. The death benefits would be taxable in the hands of the recipients.
Even then, however, his children are basic-rate taxpayers and his grandchildren do not currently pay any tax at all. Each has their own income tax personal allowance. So there is scope to manage withdrawals to minimise the tax each one pays.
As such, both of these scenarios still look favourable given the 40% tax relief on the way in. Therefore, despite the LTA tax charge, Kirk decides to boldly go ahead with making the contributions to his pension.
Martin Jones is technical resources consultant, AJ Bell