The government has re-confirmed that the pension lifetime allowance will be abolished from 6 April 2024.
It will bring cheers from savers with large pension pots and high-paid workers with generous final salary schemes.
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The lifetime allowance has long been controversial, essentially penalising workers that diligently save money for retirement and/or make good investment decisions.
The allowance is still in place but Hunt removed the lifetime charge earlier this year, meaning pension savers won't incur penalties. The actual allowance will be scrapped in April.
But what is the pension lifetime allowance and how does it work?
What is the pension lifetime allowance?
The pension lifetime allowance (LTA) is the total amount an individual can save into pensions over the course of their lifetime – before a tax penalty is due. The allowance applies to all the pensions you have but not your state pension.
This is true even if the reason that you exceed the allowance is that your pension investments have performed well.
How much is the lifetime allowance?
The pension lifetime allowance was £1,073,100 for the 2022/23 tax year. This is the total amount you can save across your personal and workplace pensions without incurring a tax penalty. The government previously announced that the lifetime allowance would be frozen at this level until at least April 2026.
However, in a bid to tempt older savers back to work, the chancellor said in his Spring 2023 Budget that the allowance would be abolished.
This means savers will be able to build up as much as they want in their pension pots and enjoy extra tax relief. They will not need to worry anymore that good investment growth, extra pension contributions or working longer or doing overtime could potentially cause them to exceed the lifetime allowance and be slapped with a tax fine of up to 55%.
So, it's going to be abolished?
The government published draft regulations to abolish the lifetime allowance in yesterday's Autumn Statement.
It predicts that changes to the lifetime allowance and the annual allowance on pension contributions "will increase employment by around 15,000 in 2027 to 2028, by removing some financial disincentives to continuing in employment for those with large pension pots".
Rachel Vahey, head of policy development at the investment platform AJ Bell, notes that as things stand, with the allowance in place but no charges applied, a future government could re-introduce the lifetime pension cap relatively easily.
"Passing legislation to abolish the lifetime allowance altogether makes it far more difficult for policymakers to reverse the rules again, as Labour has pledged."
She adds: "The move makes pensions more tax-efficient for thousands of higher earners who had built up pension pots worth £1,073,100 or more.
“It also means those who feared hitting the lifetime allowance can resume contributions and keep building their pension pot."
Note that the rest of this article refers to how the lifetime allowance worked prior to April 2023. The government has now removed the lifetime allowance charge, effectively rendering the allowance meaningless, and will completely abolish the allowance in April 2024.
How much is the tax penalty?
If you fully withdraw your pension as a lump sum, 55% tax is due on the excess over the lifetime allowance and is deducted immediately when it is paid out. If you take your retirement pot as pension income, 25% is due immediately, then any future pension withdrawals are taxed as income.
Usually, your pension trustees or pension scheme administrator will deduct the tax charge from the pension and pay it directly to HMRC.
Who does the lifetime allowance affect and how is it triggered?
Cuts to the lifetime allowance mean more and more people have been affected by it – not just the very wealthy – with NHS GPs being one, recent, high-profile example.
The allowance had previously gone up with inflation each year, reaching £1.8m in 2010/2011, but had then been frozen or cut by successive chancellors.
According to government figures, 11,660 retirement savers had to pay a tax charge in the 2021/22 tax year because they had put too much into their pension pots and breached the lifetime allowance.
Your progress towards the lifetime allowance is assessed:
- When you start to take an income from your pension pot and
- When you hit age 75
Lifetime allowance calculations apply differently to defined contribution and defined benefit pensions. Many people will have both types so it is important to include them both when you are assessing whether you might be impacted by the lifetime allowance. Your pension might be well below the current lifetime allowance now, but investment growth over the long term means you could end up with a lifetime allowance issue in the future.
Helen Morrissey, head of retirement analysis at the wealth manager Hargreaves Lansdown, gives an example of how someone “earning £50,000 a year, contributing 8% with investment returns of 5% per year, aged 40 with defined contribution pensions worth £400,000 could breach the lifetime allowance by the time they hit 65”.
How to work out if the lifetime allowance applies to you
The lifetime allowance calculation works differently for defined contribution pensions and defined benefit pensions.
Defined contribution pensions
For personal pensions, stakeholder pensions or self-invested personal pensions (Sipps), the lifetime allowance is assessed according to the value of your pensions. If due, a tax charge would only happen if you moved the funds into drawdown, purchased an annuity or died before age 75.
Defined benefit pensions
For defined benefit pensions, such as final salary and career average schemes, that don’t have a fund value, pension benefits are valued at 20 times the pension received, plus the value of any tax-free cash payable – when retirement benefits are taken.
Gary Smith, financial planning director at wealth manager Evelyn Partners, gives an example: “If a defined benefit scheme provides an annual pension of £40,000, plus a lump sum of £120,000, the value of these benefits would be £920,000 (£40,000 x 20) + £120,000”.
Beware the second LTA check
There is a second LTA check at age 75 for those in drawdown that catches out many people. It measures the growth in the value of the pension since it entered drawdown and the growth is measured against the client’s remaining LTA.
What happens if your pension exceeds the LTA?
In the event you exceed the lifetime allowance, tax charges will apply to the amount you’re over. How you take the excess will dictate the rate of tax payable.
Evelyn Partners gives the following example:
Stage 1 – tax-free cash
- Your tax-free cash lump sum can’t exceed 25% of the lifetime allowance
- So, if someone has a £1.2m Sipp the maximum tax-free cash would be £268,275 (25% of the current allowance of £1,073,100) and not £300,000 (25% of £1.2m)
- But it is typically the income that is subject to the lifetime allowance tax charge
- If the excess is taken as a lump sum the excess would be taxed at 55%. However, where the excess is paid as an income the excess is taxed at 25%
Stage 2 – taking your pension
- Again using an individual with a Sipp worth £1.2m, if they moved the full value into drawdown, a tax-free lump sum of £268,275 would be paid, using up 25% of their lifetime allowance, with the remaining £931,725 going into the drawdown fund.
- They would only retain a lifetime allowance of £804,825 (75% of £1,073,100) so, if income is taken, £126,900 would be taxed at 25% (£31,725).
Inheriting a pension
- If the same individual had died, prior to taking their retirement benefits and before their 75th birthday, and the beneficiary opted to take the value as a lump sum, the amount up to the lifetime allowance would be paid tax-free, with the excess of £126,900 subject to a 55% tax charge of £69,795.
- The beneficiary would receive an overall lump sum of £1,130,205 or 94.18% of the Sipp value.
What can I do to avoid the LTA?
To avoid going over the lifetime allowance you could:
- Stop saving into a pension and use an alternative savings method, such as an Isa
- Draw your pension, before it exceeds the LTA, and enjoy the income
- Apply for an LTA protection, if available
What are LTA protections?
Protections – Fixed Protection (FP2016) or Individual Protection (IP2016) – can help you mitigate the effects of lifetime allowance charges.
Fixed protection will fix your LTA at £1.25m but only if no pension benefits are accrued after 5 April 2016 – this includes personal and employer contributions and building up further benefits in a final salary scheme. You can only apply if you do not have protection from a previous year, other than Individual Protection 2014.
Individual protection fixes your allowance at the value of your pensions as of 5 April 2016, up to a maximum of £1.25 million. You can continue to make and receive contributions, but you will only qualify if your pensions were worth more than £1 million in total as of 5 April 2016 and you do not hold any other protections.
Helen Morrissey, at Hargreaves Lansdown, advises: “The protection schemes are very complicated so it is important to speak to HMRC to make sure you don’t fall foul of the rules.”
Laura Miller is an experienced financial and business journalist. Formerly on staff at the Daily Telegraph, her freelance work now appears in the money pages of all the national newspapers. She endeavours to make money issues easy to understand for everyone, and to do justice to the people who regularly trust her to tell their stories. She lives by the sea in Aberystwyth. You can find her tweeting @thatlaurawrites
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