Lifetime allowance tax could trap more than a million pension savers
Initially introduced in 2006, the pension lifetime allowance has been gradually reduced from its peak of £1.8m. For most people, the lifetime allowance in the current 2019/20 tax year is £1,055,000. The Lifetime Allowance is expected to increase each year on the 6th of April in line with the Consumer Price Index.
It’s an important tax charge to understand, as those with pension benefits exceeding the lifetime allowance have to pay a charge on their excess benefits value.
The lifetime allowance is assessed each time you take a benefit from a pension scheme which is known as a Benefit Crystallisation Event. At this point, the value of the pension benefit is compared against your remaining lifetime allowance, to work out if the lifetime allowance charge is due.
The value of pensions is calculated differently depending on the nature of the pension scheme. For a personal pension, it’s relatively simple to compare the value of the pension pot against the lifetime allowance, as both are capital amounts. For the defined benefit pension, the value is calculated by multiplying the annual pension by 20 to get a capital amount to compare with the lifetime allowance.
Other pension benefits assessed against the lifetime allowance including certain tax-free lump sum benefits paid to your survivors if you die before your 75th birthday. There’s also a lifetime allowance check made against any unused pension funds and those funds in drawdown once you reach your 75th birthday. This will check the increase in the fund value between crystallisation events and the age of 75.
A new analysis of the lifetime allowance has concluded that a significant number of retirees could face a lifetime allowance charge in the future. The analysis, carried out by insurer Royal London, estimates that around 290,000 people already have pension benefits more than the lifetime allowance.
They are forecasting that more than a million people risk breaching the lifetime allowance by the time they retire. This follows three cuts to the lifetime allowance since 2010.
When the value of your pension benefits exceeds the lifetime allowance, you can end up paying a 55% charge on the excess above the allowance where the excess is taken as a lump sum.
Among the findings from this analysis by Royal London was around 290,000 non-retired people who have already thought to have accumulated pension rights over the lifetime allowance.
Despite holding substantial pension benefits, less than half of these people are thought to have applied for lifetime allowance protection, which can preserve a previously higher lifetime allowance and reduce the tax charge paid.
Royal London also found that almost half of people who already have pension benefits over the lifetime allowance continue to add to their pension wealth, potentially exacerbating the future tax charge. Among those non-retired people who do not yet have pension wealth exceeding the lifetime allowance, there are an estimated 1.25 million who can expect to breach the allowance by the time they retire.
Those most likely to breach the lifetime allowance include relatively senior public sector workers with long-service, who have defined benefit pensions that will exceed the lifetime allowance. This is especially likely as those in the public sector now have to work until age 65, rather than 60.
Another group likely to get caught in the lifetime allowance trap are relatively well-paid workers in defined contribution pension schemes where they receive a generous contribution from their employer.
Typical salary ranges of those likely to fall into this category are £60,000 to £90,000 a year. The very highest earners are less likely to get caught in a lifetime allowance trap because they face limits on how much they can contribute to a pension each year due to tapered annual allowance restrictions.
The rising number of people likely to exceed the lifetime allowance in the future is the result of the allowance rising in line with CPI price inflation but wages and pension funds typically rising much faster. As a result, the lifetime allowance is likely to ‘bite’ progressively more severe over time, affecting hundreds of thousands of people who don’t necessarily think of themselves as wealthy.
Commenting on the research, Steve Webb, Director of Policy at Royal London said:
“This research shows, for the first time, how the drastic cuts in the Lifetime Allowance mean that large numbers of workers will now be caught by a limit that was originally only designed for the super-rich.
“It is shocking that over a quarter of a million people have already breached the LTA and that many of these are still adding to their pensions. They are likely to get a nasty shock – and a big tax bill – when they do finally draw their pensions.
“And more than a million further workers who are not currently over the LTA could find themselves in breach unless they take action. This is truly a Lifetime Allowance timebomb.
“Many workers, especially those in Defined Benefit pension schemes, will have little idea that this is an issue and could be heading for a nasty jolt. The
“Government needs to think hard about how to make sure people are aware of these limits in time to make alternative arrangements, and individuals need to take expert advice if they are to avoid potentially huge tax bills.”
There are schemes in place designed to protect your lifetime allowance namely Fixed Protection and Individual Protection. However, before you take out lifetime allowance protection, it’s essential to seek professional independent financial advice. Do speak to us if you have any questions.
Duncan Arthur APFS MCSI Cert (DM)
Chartered Financial Planner
Blackadders Wealth Management LLP