‘Chasing £700 pension relief could cost us £60,000 in tax’: why advice is critical
The couple, both 49, have accrued impressive pension pots – the wife has an estimated £900,000 across four pension schemes and is forecast to go above the current £1m Pension Lifetime Allowance, while the husband has amassed £400,000 in his.
As such, the wife has taken early retirement while the husband continues working to build up his pension pot.
Given their circumstances, the couple sought financial advice in 2014 where a report was prepared for them by their IFA, but they didn’t continue meetings with their financial adviser over the next few years.
When they received a flyer from their accountant informing them that non-workers and/or those not paying income tax could contribute up to £2,880 into their pension each tax year and gain automatic tax relief of 20%, the husband thought his retired wife would benefit.
Without seeking advice, he transferred £2,880 from their joint account in late April 2016, believing his actions would add a further £3,600 to his wife’s future retirement income.
But after seeking help from Dentons Pension Management and setting up a Self-Invested Personal Pension (SIPP), the husband discovered he had made a very expensive mistake.
Martin Tilley, director of technical service at Dentons told the husband that his wife could apply for Fixed Protection 2016 to avoid a tax charge as long as no contribution had been made in that tax year (after 5 April 2016).
As the husband had made a pension contribution in late April 2016, he had inadvertently made her ineligible to protect her pension pot if it rose above £1m.
Based on a 6% return over the next five years, the wife could have accrued £1.24m by the time she reaches her 55th birthday. But as the protection does not apply, £240,000 would be above the threshold, meaning it’s subject to tax totalling £60,000.
Tilley said: “It was an enormous blunder based on the best intentions. This self-made decision could now cost the wife £60,000 for the sake of a £700 tax-relief saving from the government.
“The moral of the story is to go and see a financial adviser. If you’re only seeing them every three years, you’re missing a trick as legislation changes every year.
“A little knowledge can be very dangerous and this case shows the importance of taking advice and keeping in touch with an adviser.”
He added that the only fortunate thing about this scenario is that the Lifetime Allowance is due to increase in line with the Consumer Price Index (CPI) level of inflation. The amount will be based on this September’s CPI figure (published in October) and will take effect in April 2018.
Tilley said: “Based on average inflation index of 2.5%, it could increase the LTA to £1.131m so the excess would be £108,000 and the tax payable falls to £27,150.
“In five years’ time this allowance could be much higher, so the situation may not be quite as bad as originally thought.”
What to do if you think you’ll breach the allowance
In certain circumstances you can apply for protection to help reduce or even avoid a lifetime allowance charge:
Fixed Protection (FP) 2016
This will give you a lifetime allowance of £1.25m (the amount before it was reduced to £1m last year) and while there are no time or other restrictions regarding the size of your pension savings, you must stop contributions to your pot on or before 5 April 2016 if you want to fall back on this protection at a later date.
This includes both personal contributions into your defined contribution pension scheme, as well as the accrual of further benefits into a defined benefit pension scheme.
If benefits accrue or contributions are made after 5 April 2016, it could invalidate the FP 2016 (as seen in the above case study), meaning you could be charged either 25% on the excess when you withdraw the money as an income or 55% if it’s withdrawn as a cash lump sum.
Further, if you join or start saving into a new pension arrangement after this date, again you may invalidate the protection.
You can apply online for Fixed Protection 2016 here.
Individual Protection (IP) 2016
The main difference between FP 2016 and IP 2016 is that the latter allows you to continue to contribute into your pension pot but it will only provide partial protection – the amount you’ve saved as at 5 April 2016 – anywhere between £1m and £1.25m.
In order to apply for IP 2016, you need to know how much your pension pot is worth as it stands on 5 April 2016. You should contact your pension provider or providers if you’ve several schemes to see the total value. If you go above the amount protected, it will be subject to tax as above.
Again, you can apply online for Individual Protection 2016 here.