Stop living in fear of the pensions lifetime allowance
Breaching the lifetime allowance (LTA) for pension savings can be expensive. So how can you cut the cost?
Millions of savers face punitive tax charges on their pension funds, courtesy of strong global stockmarkets over the past 12 months and a sleight of hand from the chancellor of the exchequer. But while the lifetime allowance (LTA) on pension savings is becoming a headache for more and more people, don’t turn your back on pensions because of it.
The lifetime allowance, £1,073,100, targets the amount of savings you can build up inside tax-efficient pension wrappers, including your own and your employer’s contributions, the value of tax relief on those savings, and the investment returns they earn. There is no law against breaching it, but if you do, you will pay extra tax when you cash your savings in: 55% on the excess if you take it as a lump sum, or 25% if you take it as income, with your normal rate of income tax then payable on top.
A five-year freeze
Strong stockmarket returns have increased the value of many savers’ pension funds markedly over the past year. And in March, the chancellor announced that he was freezing the lifetime allowance at its current level until at least 2025, rather than increasing it in line with inflation, so more people will now be hit by the cap. Even before March’s Budget, the insurer Royal London estimated 290,000 Britons already had pension savings above the lifetime allowance, with another 1.25 million set to follow suit. That second figure is now rising.
All of this sounds like unmitigated bad news – and a reason to stop saving in a pension if you are worried about falling foul of the lifetime allowance. Why put £100 into a pension plan if it is worth as little as £45 after an lifetime allowance charge?
But that would be a mistake for most people. For one thing, there may be ways to mitigate at least some of your lifetime allowance exposure. And even more importantly, even savers who cannot avoid the charge will still often be better off. Consider that second category first. If you are in a workplace pension scheme, your contribution will be topped up by your employer. Assuming it matches your contribution, saving £100 actually adds £250 to your pension after basic-rate tax relief on your savings and your employer’s cash. Even if you end up paying 55% tax on that £250 because of the lifetime allowance, you will still be left with £113, 13% more than you paid in.
Self-employed people who do not get an employer’s contribution will find it harder to make the numbers add up. But even here, some will be better off, particularly if they are on higher rates of income tax while working, but lower rates when they start drawing pension benefits. Furthermore, you get other benefits from a pension plan: life insurance, dependants’ pensions and inheritance-tax advantages, for example, as well as investment growth on your savings, which changes the calculation. What about reducing the impact of breaching the lifetime allowance? There are several options. First, if you have a mix of defined-benefit and defined-contribution schemes, there are certain flexibilities.
The former – where your retirement income is guaranteed by your employer – are tested for the lifetime allowance in a different way, and the tax-free cash you take is tested differently from your income. You may be able to reduce your lifetime allowance exposure by taking defined-benefit benefits before you cash in your defined-contribution plans, or by taking less tax-free cash.
Delay your benefits
Another option could be to delay drawing your pension benefits, particularly if you are still working. This could see you move on to a lower rate of income tax in retirement, reducing the effect of the lifetime allowance if you take your excess savings as income. If you can delay taking some benefits until much later in retirement, moreover, you benefit from the fact that gains made after the age of 75 do not normally count towards the lifetime allowance. These issues can get quite complex and often require some tricky value judgements, so independent financial advice often proves worthwhile. But the bottom line is that unpalatable though lifetime allowance tax charges may be, giving up on pension saving may leave you even worse off.