Lifetime Allowance – Will your pension be hit?
From April 2016 the government has restricted the tax-breaks on pensions by reducing the ‘Lifetime Allowance’ (LTA).
If the combined value of your pensions exceeds this allowance you could face additional tax charges.
Read on to find out:
- if you are affected
- how to calculate the value of your pensions
- what steps you can take to minimise tax bills
What is the lifetime allowance?
This is the maximum sum you can build up in pensions and receive tax breaks on over your lifetime. This lifetime allowance includes both company and private pensions, such as defined contribution and final salary pensions. It doesn’t include the value of your State Pension though.
How much can I have in a pension?
The LTA is currently £1.25m, but this reduced to £1m from 6 April 2016.
The government has said that from 2018 it will be increased each year in line with inflation, as measured by the Consumer Price Index (CPI).
Will my pensions exceed the lifetime allowance?
If you have a generous workplace pension or have saved significant amounts into personal pensions, it is worth checking the value of these pensions against the LTA to ensure you don’t go over this limit.
This isn’t always straightforward as the method used to determine the value of your pensions depends upon the type of pension arrangements you have and whether they are paying out yet or not:
Read on to find out how the type of pension you have will be impacted by the new lifetime allowance (LTA).
Defined Contribution (DC) pension
- This type of pension is often built up from personal and employer contributions that are invested over your lifetime to provide a pot of money for retirement.
- Here you just need the total fund value, which can be found on your annual statement (you may wish to get an update depending on how old your statement is).
- If you have more than one DC pension you need to add these totals together.
- Remember it is the size of the pension fund, not just the contributions you or your employer have made that is relevant for the LTA, so this includes investment growth.
Think about the future
If you are still several years from retirement, think about how these funds might grow in future and whether that means they could exceed the LTA.
If so, you may want to consider limiting future contributions, although be aware that this may mean losing valuable employer contributions.
Defined Benefit (DB) pension
- With these pensions, your retirement income is based on salary, and the length of time you worked for your employer. Rather than show a ‘fund value’, your annual statement shows the pension you are on track to receive at retirement.
- For LTA purposes you need to multiply this annual pension by 20 to get the theoretical ‘fund value’. So those on track for a pension of £18,000 a year, would be deemed to have a fund worth £360,000.
- Many final salary schemes offer a tax-free lump sum, before income begins. This may be in addition to your full pension income or by reducing your pension income to provide the lump sum. The calculations can be difficult and we would encourage you to speak to your financial adviser firstname.lastname@example.org
Pensions already paying out
If you have started taking an income from a DC or DB pension since the LTA was introduced on 5 April 2006, you should have been assessed already. Your pension provider or financial adviser will be able to confirm the figure that was calculated.
If you were already in receipt of a pension before 5 April 2006 and have continued to save into other pensions since then where no subsequent lifetime allowance tests have been triggered, different rules apply:
- For final salary (DB) pensions the calculation is 25 times your current annual pension.
- For drawdown pensions the calculation is 80% of 25 times your current annual drawdown limit. (“drawdown” or “income drawdown” is where you take income or tax-free cash from your pension and keep the remaining pot invested.)
This is a complex area and we would encourage you to discuss this with your independent financial adviser.
When does the Lifetime Allowance come into force?
Neither the tax authorities, nor your pension providers, are checking the value of your pensions against the LTA on a daily basis. Don’t expect a warning letter as you approach this limit as it’s your responsibility to check.
But your pension funds ARE tested against the LTA at key dates
- From the age of 55 you are now free to cash in or access part, or all, of your pension. Once you take a lump sum or income from your pension it is tested against the LTA. At this stage it’s important to know that it is the TOTAL value of the pension that you access that is assessed against the LTA, not your total fund value. For example, if you have a pension fund worth £100,000 and wish to take the tax-free cash sum of £25,000, you will need to access the full £100,000 which will use up 10% of your LTA (based on an LTA of £1 million). However, if you wanted to take a lump sum from your pension of say £25,000 where 25% would typically represent the tax-free cash sum and 75% would typically represent taxable income, as only £25,000 in total is being accessed, you will only use up 2.5% of your LTA at that time.
- On your 75th birthday, any pensions you’ve not cashed in or accessed are tested against the LTA. In addition, any existing drawdown pensions will be re-tested against their original value.
- If you die before the age of 75 any untouched pensions will be tested against the LTA to ensure this limit has not been breached.
- If you transfer some, or all, of your pension into a “Qualifying Recognised Overseas Pension Scheme” before the age of 75, only the value of the funds transferred are tested against the LTA.
How much tax will I pay?
If, when tested, the value of your pension exceeds the LTA you’ll face a tax charge on the amount that is over the limit. The exact charge will depend on how this excess is paid out.
- If the excess is paid out as lump sum it is subject to a 55% tax charge.
- If it is paid in the form of a pension income, this ‘excess’ is subject to a 25% tax charge, in addition to the income tax charged on this pension. Remember taking this excess as income, on top of other earnings/pension income, can push you into the next tax bracket.
You can still put money into a pension once you exceed the LTA limit, but will face tax charges on this excess.
My pension could exceed the LTA. What do I do next?
Each time the government has reduced the LTA, it has set up various ‘protection schemes’ to safeguard those in this position.
There are a number of schemes in place, but in essence these give savers their own tailored LTA. The exact amount will depend on the value of their pensions when these new rules came into force and the protection they applied for. Savers have to apply to get this protection. If you don’t you could be hit with tax charges.
You need to look at the terms carefully as in some cases you may not be able to make further pension contributions if you want to protect this higher LTA. This may require certain actions on the part of you, the individual, and should be considered ahead of the date the new lower LTA is introduced.
What are my options?
From April 2016 the government introduced two new forms of protection that can be obtained.
Fixed protection 2016
This gives you a LTA of £1.25m, or the prevailing LTA, whichever is higher.
This effectively allows you to lock your LTA into the current, higher rate, but also means that if the LTA does increase again you will not be disadvantaged.
However, for this to be valid you cannot make further pension contributions or actively accrue further pension benefits in a final salary pension scheme, on or after 6 April 2016.
Individual protection 2016
Here, your LTA is set at the value of your pensions on the date the lower allowance is introduced (6 April 2016).
The value of your pensions must be between £1m and £1.25m to qualify. Unlike Fixed Protection you can continue to make contributions, but any pension in excess of the relevant LTA will be taxed when tested.
Similar schemes operate from when the lifetime limit was cut from £1.5m to £1.25m in April 2014. Those whose pension fell between these limits at this date may still be able to apply for individual protection 2014.
How do I apply for the protection?
You can apply to HMRC after 6 April 2016. The latest information from HMRC is that there will be no application deadline for these protections.
However, to rely on the relevant protection, you must apply before your pension is tested against the LTA and must have adhered to the relevant conditions. This applies even when the benefits being taken are worth less than £1 million.
The application process is expected to be online from July 2016. If you wish to rely on protection ahead of July 2016 you should write to HMRC who will write back confirming protection status. A full application will still need to be made after July.
It is still possible to apply for Individual Protection 2014 where the LTA was cut from £1.5m to £1.25m. To apply your pension fund had to be between these levels on 5 April 2014. This would provide you with an individual lifetime allowance equal to the value of your pension fund on 5 April 2014, subject to a maximum of £1.5m.
What to do if you need help?
If you would like to discuss this topic please speak to your independent financial adviser. Please contact Nick Lawson: email@example.com or call 01904 655202.
Please note that the value of any tax benefits will depend on individual circumstances and all tax rules may change. You cannot access your pension until age 55.
Alternatively Pension Wise is a free and impartial government service that helps you understand your pension options. Find out more at pensionwise.gov.uk