I have written in a few places recently about the pensions ‘lifetime allowance’ or LTA – about how easy it is to hit the limit, and about how the system is remarkably biased towards those with defined benefits pensions.
However, several people have asked about how the tax would be applied in practice.
The answer – as ever in pensions – isn’t simple, but it works like this: if, on your retirement, the assets inside your pension pot are worth more than £1.25m (the limit is falling from £1.5m this April) you will face extra taxes.
The first part of that tax burden will come when you take the lump sum you are (for now) entitled to on retirement. At that point, any part of the excess value that you take as cash will be taxed at 55%.
After that, you can either take the excess as a lump sum and pay 55% on the lot, or you can leave it inside your pension wrapper and simply take the income on it. If you do the latter you will pay 25% on the income from the excess as it comes.
However, as you also pay income tax on anything you take as income, the net tax rate ends up being much higher. If you are a 20% taxpayer, it is 40%; if you are a 40% tax payer, it is 55%; and if you are a 45% taxpayer it is even higher (58.75%).
What you should do will depend on your circumstances – you are unlikely to be a 20% taxpayer if you have gone over your LTA (unless something pretty major changes in our tax regime), but if you are moving abroad to a lower tax environment, it could perhaps make sense to take your excess as income.
But here’s an interesting question: we always assume that you should take care not to run up against the LTA. But is there a case for continuing to save into your pension even if you are already over the LTA?
One reader thinks so. He has a substantial amount in his Isas already, and fills them up every year (so no more to do there). He also has a substantial amount in his Sipp – enough to pretty much guarantee that he will hit the LTA. Yet he is still contributing up to the annual allowance every year, and plans to keep doing so.
He is paid PAYE via a “fantastically flexible employer” who allows him to pay as much to his pension as he likes every year via salary sacrifice. This means that he gets his 40% income tax rebate. Then his 2% National Insurance contributions and the 13.8% NI that his employers usually pay all go in to his pension too.
Look at this as £1,000 of gross salary. If he takes it as income immediately, he will get £580 (after paying 40% in income tax and 2% in NI). But if he puts it in his pension it turns into a contribution of £1,138 (including the employer’s NI).
If you invest £580 over 27 years (our reader is 38) at 6% you end up with £2,918.99.
For the sake of simplicity, let’s ignore any income and hence income tax you might have paid over the years, and just consider all the returns to be capital gains taxed at 28% (our man is still a 40% taxpayer). That makes the final return £1,751.40.
Invest £1,138 over 27 years and you get £5,727.25. Assume that (which has rolled up entirely income- and capital-gains tax free) is all taxed at 55%, and we get a final return of £2,577.
So there you go. The fact that you will go over the LTA doesn’t automatically mean that you should stop saving – in some cases (assuming no changes to the various tax rates and assuming you have no better use for the money) the LTA excess rate will be a wealth tax (for that is what it is) well worth paying.