What is the Pension Lifetime Allowance?
The pension lifetime allowance is the maximum you’re allowed to receive from your pension arrangements without having to pay a tax charge. If you exceed your lifetime pension allowance, it will be subject to a Lifetime Allowance Charge. Every time you take benefits out of your pension, you use up a proportion of your pension lifetime allowance.
The pension lifetime allowance is £1m in the 2016/17 tax year and, from 2018, it will rise and fall in line with inflation.
Contents
- How much is the lifetime allowance?
- How much lifetime allowance do you have left?
- Approaching your lifetime allowance?
- Exceeding your lifetime allowance
- How to protect your lifetime allowance
- Tax-efficient pension alternatives
- Need lifetime allowance pensions advice?
Written by:
Michael Englefield
Content Manager at Drewberry
How much can I contribute to a pension in total?
The government first introduced the lifetime allowance back in 2006 and was initially set at £1.5m. The pension allowance then rose gradually each year until it reached £1.8m in 2010. From 2010 onwards, however, pension reforms have successively cut the lifetime allowance.
The 2015 Summer Budget cut the total pension lifetime allowance further; from the start of the 2016/17 tax year, the lifetime allowance is worth £1m.
The pension lifetime allowance will begin to rise in line with inflation from the 2018/19 tax year onwards.
Note that the pension lifetime allowance is different from your annual pension allowance, which refers to how much you can pay into your pension in any given tax year. Drewberry’s Pension Annual Allowance Calculator can help calculate your annual pension allowance.
Although a £1m pension lifetime allowance might sound like an enormous sum of money to have in your pension pot, it won’t buy as large a retirement income as you might think.
This is based on current annuity rates, especially if you’re looking index-link your income to protect it from inflation in the years to come.
Neil
Pensions Advice
Robert
Income Protection
How to calculate your remaining pension lifetime allowance
To find out how much of your lifetime allowance you’ve used, you’ll need to contact your pension provider who should be able to tell you.
If you have more than one pension, make sure you tot up what you’ve used in all of the different schemes you belong to.
What counts towards your lifetime allowance depends on the type of pension scheme you have.
Lifetime allowance and defined contribution pensions
In a defined contribution or money purchase pension scheme, you calculate your lifetime allowance based on the value of your pension pot you’re going to use to fund your retirement plus any lump sum.
Lifetime allowance and final salary pensions
If you have a defined benefit or final salary pension, then the calculation of what counts towards your lifetime allowance is a little more complicated.
Here, you multiply the annual pension due from by 20, and add any tax-free cash lump sum. For example, you can receive an annual pension of up to £50,000 before you are hit by the 55% tax charge, as £50,000 multiplied by 20 is £1m (assuming you take nothing as a cash lump sum),
Transferring out of a final salary pension could hit your lifetime allowance
A final salary pension transfer involves you transferring out of a defined benefit pension and into a defined contribution scheme. Final salary pension funds are increasingly keen to get members to transfer out of the plans, as the promise of a lifelong income has proved to be expensive.
As such, DB pension schemes are currently offering large cash lump sums to encourage members to leave schemes, known as cash equivalent transfer values or CETVs. These can sometimes be upwards of 30 times the annual benefit that member is entitled to.
If you’re interested in seeing how much your final salary pension scheme could be worth if you transfer out, the Drewberry Final Salary Pension Transfer Calculator can help.
However, it’s important that you remember that although a large DB pension transfer value might seem tempting, it could have big implications for your pension lifetime allowance. That’s because, inside a final salary scheme, the proportion of your lifetime allowance you’ve used is calculated as 20 times your annual benefit.
If you leave your defined benefit pension for a CETV worth 35 times your annual benefit, though, you might find yourself inadvertently over the lifetime allowance and subject to the Lifetime Allowance Charge. That’s why seeking professional advice is essential to avoid an unexpected tax bill.
Peter Banks
Wealth and Investments Specialist at Drewberry
Managing your pension lifetime allowance if you’re approaching your maximum pension contributions
If you are close to the lifetime allowance or think you could exceed it soon, you should seek professional financial advice to help minimise any tax charges going forward.
You will probably need to stop making contributions, although this can be a difficult decision to make, especially if you receive employer contributions into your pension too.
An pensions adviser will be able to weigh up the various options and help you decide on the best course of action.
Don’t assume you won’t be affected these charges if your pension pot is currently well below the allowance.
For example, if your pension pot is currently around £700,000, and you are planning on stopping work in 10 years, based on investment returns of 5% a year, it could easily grow to £1m over this period, even if you make no further contributions.
Tom Conner
Director at Drewberry
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What happens if you go over your lifetime allowance?
How much you’ll be taxed in Lifetime Allowance Charge will depend on how you take your pension. If you take your pension as a lump sum, any amount exceeding your lifetime allowance is taxed at 55%, which will be deducted by your pension provider.
If you’ve exceeded your lifetime allowance and take your pension fund as income, e.g. purchasing an annuity, you’ll attract a Lifetime Allowance Charge of 25%, in addition to the usual tax on your pension income.
So a higher-rate taxpayer with a pension income of £10,000 per year who had exceeded the lifetime allowance would face their pension income being cut to £7,500 by the Lifetime Allowance Charge.
They would then have to pay income tax at 40% on the £7,500, reducing it further to £4,500. This is effectively the same as the 55% charge that would be levied on a lump sum.
In a defined benefit scheme, your pension plan may agree to pay the tax to HMRC for you and compensate by cutting your annual benefit.
Your retirement doesn’t need be subject to such punitive tax charges. Act today and seek financial advice if you think you might exceed your lifetime allowance to stop these rules applying to you.
Can I protect my pension lifetime allowance?
Depending on your individual circumstances, it may be possible to protect your pension benefits above the lifetime allowance.
As of the start of the 2016/17 tax year – the first year of the £1m reduced annual lifetime allowance – there are three protections you can apply to HMRC for if your pension benefits exceed the £1m lifetime allowance on 5 April 2016.
Protecting your lifetime allowance: Individual protection 2016
- Individual protection 2016 protects your lifetime allowance to the lower of either the value of your pension(s) at 5 April 2016 or £1.25m.
- You can’t apply if you already have individual protection in 2014, which protected your lifetime allowance at £1.5m rather than the £1.25m it fell to that year.
- The same is true if you have primary protection, the equivalent offered by HMRC in April 2006 to those with pensions exceeding the newly-introduced lifetime allowance of £1.5m.
- You can continue contributing to your pension(s), but must pay tax on all money taken from your pension(s) that exceed your protected lifetime allowance.
Keeping your lifetime allowance: Fixed protection 2016
- Fixes your lifetime allowance at £1.25m.
- You cannot continue building your pension except in limited circumstances or you’ll lose the protection and pay tax on any pension(s) above the standard lifetime allowance when you take your pension(s).
- You can only apply if you or your employer have’t added to your pension(s) since 5 April 2016 and you opted out of any workplace schemes by 5 April 2016.
- You can apply if you already have individual protection 2014, but the fixed protection 2016 will be dormant until you lose previous protection.
- You can’t apply if you have primary protection or fixed protection from previous years, such as 2014.
Preserve your lifetime allowance: Individual protection 2014
- Individual protection 2014 protects your lifetime allowance to the lower of either the value of your pension(s) at 5 April 2014 or £1.5m.
- You must apply for this protection before 5 April 2017.
- You can continue contributing to your pension(s), but must pay tax on all money taken from your pension(s) that exceed your protected lifetime allowance.
- You can still apply if you already have fixed protection 2014 or fixed protection 2016, but if you have fixed protection 2016 it will become dormant and individual protection 2014 will be opened.
- For all other protections, individual protection 2014 will stay dormant until you lose or give up your previous pension.
- You can’t apply if you have primary protection.
Are there any tax-efficient alternatives to pensions?
If you are close to, or have already exceeded the lifetime allowance, then you’re likely to want to cease contributions into your pension and look for alternative tax-efficient options.
ISAs or pensions?
Individual Savings Accounts (ISAs) are one of the best ways to save, as returns are free from both income tax and capital gains tax (CGT). From the 2017/18 tax year, you can invest up to £20,000 pa in ISAs, either into stocks and shares or cash, or a combination of the two.
There are thousands of different ISA funds to choose from, so seek advice if you need help building a balanced portfolio which will meet your investment objectives.
If you are particularly risk averse, or only investing over a short-time frame, as cash ISA is likely to be a more suitable choice than stocks and shares. Remember, however, that if you do put savings into a cash ISA, the purchasing power of your money is likely to be eroded by inflation over time.
More risk: venture capital trusts and enterprise investment schemes
If you have a strong appetite for risk, then other options you may want to explore include venture capital trusts (VCTs) and enterprise investment schemes (EISs).
VCTs are a type of investment fund similar to an investment trust that invest in very small companies, while EIS helps smaller companies to raise finance by providing tax relief to those who invest in the shares of those companies.
There are significant tax benefits offered to both EIS and VCT investors, but it’s important you understand the risks involved before investing.
Pension Lifetime Allowance Advice
If you have further queries with regards to the lifetime allowance or would like some advice on what to do please do not hesitate to pop us a call on 020 8432 7333.
Our expert financial advisers will be able to go through all the various different options with you, so that you can keep tax bills to a minimum and ensure your savings are working as hard as they possibly can.
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