What is the pension lifetime allowance?
If you have been saving into your pension for some time now you may have heard the term "lifetime allowance". Here's what that means.
According to recent government figures, the pension lifetime allowance caused 8,600 retirement savers to pay a penalty for putting too much into their pensions in the 2022/23 tax year. But what is the pension lifetime allowance and how is it triggered?
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 current pension lifetime allowance is £1,073,100 for the 2021/2022 tax year. This is the total amount you can save across all your pensions without incurring a penalty tax. The lifetime allowance will be frozen at this level until at least April 2026.
How much is the penalty tax?
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 are being affected by it – not just the very wealthy – with NHS GPs being one, recent, high-profile example.
Your progress towards the lifetime allowance will be assessed:
1) when you start to take an income from your pension pot and
2) 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, senior pensions and retirement analyst at wealth manager Hargreaves Lansdown, gives an example of how someone: “earning £50,000, 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 (SIPP) 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 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 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, a financial advice firm, 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 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.”