How to avoid the lifetime allowance charge
The lifetime allowance – the amount you can save into a pension without triggering an excess tax charge at retirement – at the time was £1.25m. Anyone who exceeded this limit was hit with a 25% tax bill on the excess if the money was withdrawn as income, or a 55% bill if the money was taken as a cash lump sum.
Historically, only wealthy earners were affected by the lifetime allowance. However, in April 2016, the limit was slashed to £1m meaning it would impact a much larger proportion of the population.
Understanding in basic terms of how the lifetime allowance works is essential.
Here, Steve Patterson, managing director of Intelligent Pensions, explains how to work out if you’re going to breach the allowance and what you can do to avoid a charge.
In simple terms, if you are in a final salary (defined benefit) scheme, you multiply the expected gross pension entitlement by 20 if it’s a private sector scheme or by 23 if it’s a public sector scheme and then add on the projected value of any personal pension or occupational money purchase benefits including additional voluntary contributions (AVCs). You should find this information in your annual pension statement.
If the result is more than £1m or even close to it you should definitely get advice. The reason the public sector scheme multiple is higher is that these schemes provide tax free cash on top, equal to three times the pension, whereas in private sector schemes the tax free cash entitlement is obtained by commuting off part of the pension.
What to do if you’re going to breach the allowance
In certain circumstances you can apply for protection that will help reduce or even avoid a lifetime allowance charge. However, if you’re still participating in your employer’s scheme that option will probably not be available, unless the current aggregate value of your pension benefits is already over £1m in which case you may be eligible to obtain partial protection.
This is known as Individual Protection as opposed to Fixed Protection. Individual Protection 2016 protects your lifetime allowance to the lower of the value of your pension(s) at 5 April 2016 and £1.25 million. If you continue accruing further benefits, you won’t lose the protection but you will pay the lifetime allowance charge on money taken from your pension(s) that exceed your protected lifetime allowance.
Fixed Protection 2016 fixes your lifetime allowance at £1.25 million but you would lose this if you add to your existing benefits.
If you don’t qualify for protection it may make sense to stop accruing benefits. However, that’s not a good idea if your employer is funding most of the cost. Even if you lose 25% of the additional benefits as a result of a lifetime allowance charge, 75% is still better than nothing.
In some cases it may even be better to start taking your benefits before the value reaches £1m but you can only do that if you’re 55 or over. By taking your benefits early you might incur more income tax if you’re still working, so a way around that is to transfer to a flexi-access drawdown plan where you can crystallise your benefits by taking just the tax free cash and defer your pension until you actually retire.
However, you don’t necessarily need to crystallise all your pensions at once and in some cases just crystallising one pension benefit can make the difference.
Any benefits you do crystallise will continue to enjoy tax free growth until you need the pension income which can be taken flexibly to suit your changing needs throughout your retirement years but be aware that any net gain in the value of your fund will be reassessed at age 75 for a lifetime allowance charge.
In short, professional advice is essential!