Pension Lifetime Allowance Charge
This is an issue we come across regularly as financial advisors when dealing with higher value pension funds. It is an important part of financial planning when looking at retirement income.
The Lifetime Allowance Charge (or LTA) is an amount stipulated by the government which dictates the total amount of pension savings you can build up without paying tax charges. For the 2020/21 tax year, the LTA is £1,073,100. This figure tends to increase with CPI each tax year.
The good news is that, regardless of your total pension savings, you don’t normally pay the tax charge until you access your pension or reach 75 (whichever is sooner) AND the tax charge is usually paid from the pension scheme. At its peak in 2011 the LTA was £1.8m, it then gradually reduced to £1m in 2018, before steadily increasing with CPI since then. If you have previously applied for enhanced protection you may have a higher LTA depending on when you applied.
At present, the only enhanced protections available are Individual and Fixed protection 2016, which would increase a pension saver’s LTA to £1.25m on the condition that they have not made any additional pension contributions or accumulated workplace pension benefit since 5th April 2016. If you are unsure whether or not you may be entitled to any of the above protections, speak to one of our financial advisors.
How much is the tax charge?
Quite simply the tax charge is either 25% or 55% of the excess pension savings above the LTA, depending on whether you elect to take the excess as income (25%) or a lump sum (55%).
How do I calculate my total pension savings?
In order to calculate your total pension savings to figure out whether you are approaching or have exceeded the LTA, we use a different approach depending on the type of pension.
- For Defined Contribution Pension (personal, stakeholder, auto-enrolment workplace pensions) these are calculated simply on the value of the pension at the time of asking.
- For Defined Benefit (final salary type pension schemes) – these are calculated by taking the amount of pension benefit paid in the first year and multiplying by 20, plus any lump sum that you might be entitled to.
Also, where death in service policies are written under pensions legislation, lump sums paid out upon death count towards the lifetime allowance. This would only be an issue if you took your pension but continued to work as most death in service policies will end when you leave your employment (or retire).
For the purpose of the LTA, the total amount of pension savings is added together. Let’s say that our imaginary client “Dave” has a final salary pension that will pay £30,000 a year in the first year of retirement plus a lump sum of £50,000. He also has an AVC scheme valued at £100,000 and an old personal pension valued at £60,000 – his total pension savings would be £810,000.
(20 x £30,000 = £600,000 + £50,000 = £650,000 + £100,000 = £750,000 + £60,000 = £810,000).
When does the Lifetime Allowance get tested?
Again, these are an important aspect of financial planning for retirement as it will dictate when the tax charge is likely to be applied. There are a number of events that will trigger a Lifetime Allowance test, they are known as Benefit Crystallisation Events (BCEs) and the HMRC has defined 13 of them. A few of the most common ones are;
- Taking your tax free lump sum/taking income – here the amount of the crystallised funds are tested against the LTA.
- Transferring your pension to an overseas scheme (QROPS)
- Reaching the age of 75
- Buying a Lifetime Annuity – the amount used to buy the annuity is tested against the LTA
- If a person dies before 75, pension savings are tested and taxed depending whether the pension is taken as a lump sum or income by beneficiaries.
Lifetime Allowance in Practice
Here, we take our imaginary client “Dave” and work through how the Lifetime Allowance charge would work in practice. Dave has decided to retire in September 2020 at age 60. He has total pension savings of £1.5m. For this tax year the Lifetime Allowance is £1,073,100.
Dave wants to take 25% tax free a to buy a holiday home and then, at the same time, begin to draw a regular income from the rest of the pension.
It is fairly easy to work out how much Dave has breached the Lifetime Allowance by; simply £1.5m – £1,073,100 = £426,900.
The maximum tax free cash Dave can take unfortunately is not 25% of the total pension fund. Where a pension fund exceeds the LTA the maximum tax free cash that can be taken is 25% of the Lifetime Allowance at the time. In this case 25% of £1,073,100 = £268,275.
Where tax free cash and income are paid at the same time, the tax free cash element is deemed to have been received first and is tested against the Lifetime Allowance. We know that this has used the 25% of the LTA. Dave’s remaining fund is now tested against the Lifetime Allowance as he is receiving an income.
Therefore Dave will receive £268,275 as a tax free lump sum and be liable to pay an Lifetime Allowance tax charge of 25% of £426,900 – or £106,725. The tax charge will be paid by the scheme and not deducted from Dave’s tax free cash.
After payment of the tax free cash and Lifetime Allowance charge, Dave will be left with £1,125,000 in his pension fund from which he can draw a taxable income. If Dave had decided to take the excess over the Lifetime Allowance as a lump sum, he would have paid a tax charge of 55% (or £234,795) and then been taxed at his marginal tax rate on receipt of the payment.
Planning for the Pension Lifetime Allowance
The first thing to do is calculate the total amount of your pension savings using the guide above to see if you are approaching the Lifetime Allowance. Remember that breaching the LTA isn’t necessarily a bad thing. Yes, you are likely to have to pay a tax charge from the scheme, but you enjoy the extra pension funds thereafter.
If you really want to avoid the Lifetime Allowance Charge as much as possible, it might be sensible to divert pension savings to an ISA – you can currently save up to £20,000 a year into an ISA. You might also consider reducing or stopping any AVCs. Contact you pension scheme and ask if there is a way of reducing pension accumulation. Some final salary schemes, upon early retirement, will reduce the yearly pension and lump sum to take you below the lifetime allowance. If you are married, you might also be able to divert your own pension savings to your wife or husband, providing they are well within their own lifetime allowance.
As the lifetime allowance generally increases with CPI you might want to consider delaying your retirement for a few years. You can also take a series of lump sums (if appropriate to your retirement plans) and phase your retirement in this way with the hope of pushing back the time when your pension will breach the lifetime allowance.
This guide was written by Craig Croft-Rayner, an independent financial advisor at Milestone Financial Planning. It is a for guidance only and is not in of itself financial advice. Should any of the above apply to you, please get in touch for a free consultation.