For many people, January is the month to get their personal finances organised, particularly if they have to file their self-assessment tax returns by the end of the month. However, one job that often gets overlooked – even though it could lead to a future tax headache – is a review of whether you have a problem with the lifetime allowance on pension savings.
The lifetime allowance sets a limit on the amount of tax-free savings you may build up across all your private pension schemes, including both work-based plans and any individual arrangements you may have. Currently, this limit is set at £1,073,100. There are no rules to prevent you building up more than this amount, but if you do, you’ll have to pay an income tax charge on the excess when you begin cashing in your pension benefits. The charge is payable at rates of up to 55%.
The lifetime allowance covers not only what you put into your pension – including your own contributions, those of your employer, and tax relief – but also the investment returns you earn on the savings. This makes it difficult to plan for. At age 40, say, you might have total pension savings worth £400,000, less than a third of the way to the lifetime allowance, but if those savings earn an annual return of 5% a year, your pension fund would be worth around £1.35m by the time you reach age 65. In other words, even without a further penny of contributions, you would face a significant lifetime allowance charge.
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Start planning early
The power of compound interest, particularly over the long term, is a powerful weapon for pension savers. But for those with larger sums, it does present a problem from a tax perspective. And it is something to think about early on in your planning for retirement, as that will give you more time to consider counter measures.
Don’t bank on the government helping you out with increases to the lifetime allowance. The current plan is for it to stay at today’s level for at least five years – and even beyond that date, it is difficult to imagine much appetite for measures to help wealthier savers reduce their tax bills.
Instead, think about how you might mitigate the problem. One option is to maximise your use of other types of tax-efficient savings vehicles. Individual savings accounts (Isas), which allow you to save £20,000 a year tax-free, can be helpful, while schemes such as venture capital trusts and the enterprise investment scheme might also be useful.
This is not to say you should automatically opt out of pension schemes if you are heading for an lifetime allowance problem. For one thing, doing that could mean missing out on pension contributions from your employer. It may be possible to make alternative arrangements with your employer – such as receiving benefits in pay that you can use to make savings elsewhere – so consider all your options.
The other point to make is that a lifetime allowance liability is not the end of the world – you’ll still have a more valuable pension than those below the threshold. In any case, there is no tax to pay until you begin crystallising your pension fund savings, and phasing that process can defer the liability.
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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