The pension lifetime allowance is the total value you can build up in pensions without incurring an additional tax charge. And Government figures show it is catching out an increasing number of pension investors.
Tax revenues of £126m were collected from individuals whose pension pots exceeded the allowance in 2015-16. That's an increase of 62% on the previous year.
The Chancellor reduced the allowance again on 6 April 2016. It's now at a level which the Treasury estimates will affect around 4% of retirees. As there are around 11.5m people approaching retirement, that means 460,000 people could be subject to the tax charge by the time they come to take their pension.
What is the current pension lifetime allowance?
The pension lifetime allowance was originally set at £1.5m when it was introduced in 2006. It was increased over the following years to £1.8m by 2010. But since then the allowance has been gradually reduced. The latest of these reductions in April this year brought the allowance down from £1.25m to £1m.
The lower lifetime allowance will catch out 1 in 25 people retiring in the future. Are you one of those who'll get a big tax bill?
HM Revenue & Customs (HMRC) have estimated around 55,000 individuals will have pension assets worth between £1m and £1.25m in 2016 to 2017. These people will exceed the current lifetime allowance.
What happens if you exceed the allowance?
A tax charge will be applied if the value of your pension exceed the pension lifetime allowance. The charge is applied only on the excess value over the allowance – not the entire value of your pension. And the amount of tax paid will depend on how you decide to take the excess.
Currently the lifetime allowance charge is 55% if the exceeded amount is taken as a tax-free lump sum. However, if you leave the excess in the pension to be taken as income (which would be subject to income tax) the charge is reduced to 25%. Obviously, tax rules are subject to change at any time.
Which pensions are affected?
With the exception of the State Pension, all UK pensions count towards the allowance. That's whether you have a defined contribution (also known as money purchase) pension, such as personal pensions and many occupational pensions, or defined benefit (e.g. final salary) pension.
How is the allowance measured and when?
Your pension will be measured against the lifetime allowance at one of 13 different Benefit Crystallation Events (BCEs). The most common of these is when you start take benefits from your pension. Your pension provider will tell you how much of the lifetime allowance you’ve used at the time and they'll express position as a percentage. The value of your pension is also measured at age 75 and on the payment of death benefits in some circumstances.
Things are a little less straightforward for defined contribution pensions. Here BCEs occur when you buy an annuity, take a tax-free cash, move into drawdown or make a withdrawal from a pension that is not in drawdown (such as an Uncrystallised Funds Pension Lump Sum). For example, if you decided to use a pension worth £250,000 to purchase an annuity you will have used 25% of the lifetime allowance.
Valuing a defined benefit scheme is particularly complex and is generally carried out by a qualified actuary. But you can get a rough idea of the value of your defined benefit pension by multiplying the expected income payable by 20 and then adding any additional tax-free cash. For example a final salary pension that will pay £40,000 a year is worth approximately £800,000 (which equates to 80% of the lifetime allowance used).
Pension benefits already in payment before the pension lifetime allowance was first introduced in 2006 must also be taken into account.
Will you be caught out?
Most people’s pension savings won’t reach the pension lifetime allowance. However, depending on when and how you plan to take benefits, it’s not impossible to build a £1m pension. This is particularly true if you invest your pension savings effectively.
For example, let's assume that your achieving an annual investment growth of 4% after charges. A £320,000 pension today could be worth over £1m in 30 years’ time when you eventually take benefits. But remember all investments can go down in value as well as up. You could get back less than you invest.
Even those with relatively modest retirement savings could bust the new pension lifetime allowance.
It’s important to monitor how much you're putting into your pension fund and how well your investments are performing. If your pension savings are already close to, or over, £1m you are very likely to be affected.
You can take steps to protect your pension savings though.
How to protect your pension savings
If you think you might be affected, a number of options are available to help ‘protect’ your pension from the reduction in the lifetime allowance, and subsequent potential tax charge.
There are various types of protection which will secure an allowance greater than £1m:
Individual protection 2014. This allows you to set your allowance at the value of your pensions as of 5 April 2014, up to £1.5m, and continue to make contributions. Your pensions must have been worth at least £1.25m on 5 April 2014 to qualify. The deadline to apply is 5 April 2017.
Individual protection 2016. This fixes your allowance at the value of your pensions as of 5 April 2016, up to a maximum of £1.25m and allows you to continue to make contributions. To qualify your pensions must have been worth more than £1m as of 5 April 2016.
Fixed protection 2016. This fixes your allowance at £1.25m regardless of your pension value. To qualify there must have been no pension contributions made since 5 April 2016. Any future contributions will result in loss of protection.
Have you applied to protect your pension from the latest lifetime allowance changes?
There is currently no deadline for applying for the 2016 protections. However, if you need protection you should apply before taking benefits to avoid a lifetime allowance tax charge. We strongly suggest you seek personal financial advice from our specialist pensions team if your pension benefits are close to £1m, or likely to breach the lifetime allowance in the future