Make sure you don't go over the pensions lifetime allowance
Breaching the lifetime allowance for pension savings could prove very costly, says David Prosser.
For many people, the chancellor’s announcement last week of a freeze on the lifetime allowance (LTA) for pension savings will prompt some wishful thinking. But while most pension savers do not get near the £1.073m cap – now in place until the 2025-2026 tax year – the change will affect significant numbers. The Treasury’s own figures show that it expects to be £990m better off by 2025-2026 thanks to the decision to suspend annual LTA increases.
Clearly, ministers expect many people to pay more tax, and a lot more in some cases: savings above the LTA threshold when you cash in a pension are subject to extra tax charges ranging from 25% to 55%, depending on whether you take the money as income or a lump sum.
How, then, to plan ahead for this problem? If you think there is any chance at all of breaching the threshold in the future, try to quantify your potential exposure. Remember, the cap applies across all your pension savings, not to individual plans.
Pensions are not the only tax-efficient way to save for the future. If you are concerned about breaching the LTA, other options to consider maxing out include individual savings accounts (Isas), venture capital trusts (VCTs) and the enterprise investment scheme (EIS).
The difficulty with LTA planning is that there are so many unknowns, particularly if you have a defined-contribution pension, either with your employer or independently. You will need to look at the value of your pension fund today and then make some educated guesses about how much you will contribute over the years to retirement – and the investment returns your savings will generate.
The numbers you use will make a huge difference. For instance, a 40-year-old earning £50,000 a year with a pension fund currently worth £240,000 would hit £1m by age 55 if they made contributions worth 15% of their salary over the following 15 years and earned an average annual return of 8%. However, with contributions of only 10% a year and an annual return of 4%, they would not get to £1m until age 69.
You can play around with these figures for yourself using savings calculators such as the one on the Money Advice Service website. But the important point to recognise is that if investment returns go your way, the laws of compound interest could give you an LTA problem you might not expect. Imagine our 40-year-old currently has only £100,000 of pension savings, for example. A 15% annual contribution with 8% investment growth would get him to £1m by age 62. The key is to do your sums well before any potential LTA problem materialises. That way you will have plenty of time to explore other options.
That goes for defined benefit schemes too, where the maths should be easier because you build up guaranteed pension benefits over time, according to your scheme rules and the length of your membership.
You can put your projected benefits – available from your scheme – into the LTA calculator to assess your exposure. Broadly, you work out the value of your final-salary pension benefits for LTA purposes by multiplying your expected annual pension by 20 and then adding on the tax-free cash to which you will be entitled.