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Many will consider it an enviable problem to have, but for hundreds of thousands of savers, the £1m lifetime allowance for pension savings may pose a real headache. When the government cut the allowance from £1.25m last year, it argued that just 4% of savers reached retirement with pension funds above the cap. However, pension professionals insist that up to 500,000 people could be affected.
The lifetime allowance means that anyone retiring with total private pension savings above the cap must pay punitive tax charges of up to 55% on the excess. The rule applies to both defined-contribution savings and to defined-benefit plans, where an employer guarantees you a certain level of pension in retirement. With the latter, a complicated formula determines whether you're above the cap, but if you're on target for a pension of £50,000 or more, you could be affected.
The allowance applies to the value of your pension savings, including all tax relief, employers' contributions and investment growth. That last point is what makes it important to consider the issue well ahead of retirement. There can be no hard rules, since future investment returns are unpredictable and people's circumstances vary greatly, but anyone with more than ten years to go to retirement and pension savings of more than £650,000 today should be concerned.
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If there's any chance that future investment growth and contributions will take you over the limit, it's important to act now. The earlier you take action, the easier it will be to mitigate the problem. You will need to take independent financial advice, since the options get complicated and require detailed analysis of your own circumstances.
Stopping contributions (and saving elsewhere) may be the best option. If you're also receiving contributions from an employer, you could ask for this remuneration to be paid in a different way via your salary, for example. But you must check what this means for benefits such as life insurance and dependants' pensions.
Another option for over-55s who are approaching the limit (but are not yet past it) is entering an income drawdown scheme to crystallise your pension before the cap becomes an issue. You'll be able to keep investing the undrawn money within your pension as you wish, and you may still be able to make additional contributions into the plan.
Other ways to save without paying tax
Savers worried about breaching the lifetime allowance don't have to give up on tax-efficient savings altogether. Individual savings accounts (Isas) allow you to make sizeable tax-free investments each year. This year's annual allowance of £15,240 rises to £20,000 in April, when the options for the under-40s will expand to include the new Lifetime Isa, which pays upfront bonuses to savers.
Another option is investment in very small firms through vehicles such as venture capital trusts (VCTs, see below) and the enterprise investment scheme (EIS). Both offer generous tax incentives to encourage savers to put money into what are often unproven businesses, where the risk profile is substantially higher than on conventional investments.
With VCTs, you get upfront income tax relief of 30% so a £10,000 investment costs only £7,000. You must hold on to your shares for five years or more, or you will have to repay the relief. Any dividend payments the fund makes are tax-free, and profits when you sell are not subject to capital gains tax. You can invest up to £200,000 a year.
The annual limit on EIS investment is £1m. Investors get 30% upfront tax relief. They must hold on to their EIS shares for at least three years, or repay the relief. Profits are free from capital gains tax (if held for three years) and investors can defer CGT due on profits on other investments by reinvesting such money in an EIS. You can even set loss-making EIS investments against your tax bill.
VCTs are collective funds run by professional fund managers while you can invest in the EIS either directly via individual qualifying companies or through a managed portfolio service. But don't invest simply to get a tax break. Make sure the underlying assets are appropriate for your needs.
Should you take the leap with risky fledglings?
Venture capital trusts (VCTs) are intended to encourage investment in small and growing companies hence the tax breaks. At least 70% of a VCT's assets must be invested in qualifying companies. Under current rules, a qualifying company must be no more than seven years old, have no more than 250 employees, and own assets of no more than £15m.
The most obvious downside to VCTs is that investing in these kinds of companies is a riskier proposition than investing in more established businesses. In addition, changes to the rules on what types of business qualify which broadly mean that VCTs need to invest in smaller and younger companies than before mean that they are now likely to be even riskier than they were in the past.
These tighter rules and a shortage of opportunities have meant that many VCT managers are raising less money for new and existing funds than they have done in previous years. However, Hargreave Hale has announced a £20m fundraising for its Hargreave Hale Aim VCT 1 and Aim VCT 2 funds, which invest in Aim-listed stocks. (While most VCT funds invest in unquoted companies, stocks listed on Aim the London Stock Exchange's board for smaller companies can also be qualifying investments as Aim is not a recognised stock exchange for tax purposes.)
The Hargreave Hale Aim VCTs, which are co-managed by Giles Hargreave and Oliver Bedford, have a solid track record. For those who are already keen to invest in listed smaller companies, funds such as these could offer a tax-efficient route.
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David Prosser is a regular MoneyWeek columnist, writing on small business and entrepreneurship, as well as pensions and other forms of tax-efficient savings and investments. David has been a financial journalist for almost 30 years, specialising initially in personal finance, and then in broader business coverage. He has worked for national newspaper groups including The Financial Times, The Guardian and Observer, Express Newspapers and, most recently, The Independent, where he served for more than three years as business editor.
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