The lifetime allowance is designed to limit the total pension savings that you can accumulate tax-efficiently.
Accumulated benefits in excess of the lifetime allowance are taxed at rates which largely remove the tax benefits on that excess.
The lifetime allowance applies to all the personal and occupational pensions you have, but excludes your state pension.
The lifetime allowance for 2022/23 is £1,073,100. This amount is currently frozen for the next few years.
The regular contributions you and your employer make into pensions, plus the fact investments in pensions grow free of tax, can result in your pensions growing above the lifetime allowance. The compounding of investment returns which can be well above inflation can also increase the size of your pension.
It is not unlawful to have a pension fund in excess of the lifetime allowance. You simply no longer benefit from almost all of the tax benefits on the excess pension amount. The only remaining tax benefit is in respect of inheritance tax as I explain under a separate heading below.
Check your progress against the Lifetime Allowance
To work out whether you are at risk of exceeding your lifetime allowance you need to calculate the value of all your pensions excluding your state pension benefits. The value is calculated differently depending on whether they are defined benefit or defined contribution pensions:
- For defined contribution pensions (e.g. personal pension or self-invested personal pension) the value is simply the total of all the money in your pension pots.
- For defined benefit pensions (e.g. final salary), the value is usually 20 times the pension you have earned to date plus any additional lump sum.
|Example (1) Tony has two personal pension funds valued at £94,000 and £240,000 and a self invested personal pension (SIPP) valued at £410,000. He also has a deferred final salary pension from a previous employer with a current pension entitlement of £6,200 pa. He can take a cash lump sum from his occupational pension in return for a reduced annual pension.
His progress against the lifetime allowance is £94,000 + £240,000 + £410,000 + £124,000 (i.e. 20 x £6,200) = £868,000 or 80.89% of the lifetime allowance in 2022/23. As any cash sum from his final salary pension would be by reduction of annual pension this is ignored.
Benefit Crystallisation Events
You are only liable for a lifetime allowance charge when you take money out of your pension. This is referred to as a benefit crystallisation event (BCE). If you don’t take any pension benefits by the age of 75, then at that point all uncrystallised (i.e. no benefits taken) pensions will be tested against the lifetime allowance.
A lifetime allowance test has to be undertaken every time there is a benefit crystallisation event. The benefit crystallisation events most frequently applied are:
1) Moving funds from your money purchase arrangement (e.g. personal pension or SIPP) into a drawdown pension prior to age 75, or purchasing an annuity with them prior to age 75.
2) Taking pension benefits from your defined benefit (e.g. final salary) pension scheme prior to age 75 scheme.
4) Reaching age 75 with benefits under a money purchase scheme. Both uncrystallised and crystallised benefits (i.e. a drawdown pension) are taken into account.
5) On your death before age 75 and your remaining uncrystallised funds are used to purchase an annuity or flexi-access drawdown account for a beneficiary(ies) within two years of the scheme administrator being informed of your death.
Calculating the Lifetime Allowance
If this is the first benefit crystallisation event the capital value of the pension benefits will be tested against the standard lifetime allowance applicable in the tax year in which the benefits are drawn.
Where you have previously drawn pension benefits, these must be taken into account when determining what level of benefits can be drawn within your lifetime allowance at the time further benefits are taken, or on your death.
On each occasion a benefit crystallisation event applies, the scheme administrator determines the percentage of the lifetime allowance used. This will be expressed to two decimal places and be rounded down.
|Example (2) Roger took retirement benefits with a capital value of £400,000 in the tax year 2015/2016, when the standard lifetime allowance was £1.25 million. This used up 32% of his lifetime allowance, leaving 68% available.
In 2019/2020, Roger took further retirement benefits with a capital value of £300,000. This represented 29.12% of the then standard lifetime allowance of £1.03 million. To date Roger has therefore already used up 61.12% of his lifetime allowance.
The lifetime allowance in 2022/23 is £1,073,100 so if Roger were now to take the remainder of his pension fund the first £417,221 (i.e. 38.88% of 1,073,100) would therefore be free of the lifetime allowance charge).
There are situations where it can be of benefit to transfer out of a defined benefit scheme into, for example, a self invested personal pension, although these are very much in the minority. One danger of effecting such a transfer, which can be overlooked, is the risk of triggering the lifetime allowance charge as the following example shows.
|Example (3) Peter is age 64 and is entitled to a pension of £48,000 pa from his employer’s final salary pension scheme. He has been offered a transfer value of £1.3m if he wants to forego the security of a guaranteed inflation linked pension income for life in return for controlling his own pension fund in a self invested personal pension (SIPP). This is unexpectedly attractive to him as his wife has recently died and in due course he would like to pass lump sums from his SIPP to his two children.
What Peter may have overlooked is that his inflation linked pension is within the lifetime allowance (i.e. 20 x 48,000 = £960,000) whereas his SIPP fund will be in excess of the lifetime allowance and subject to a tax charge when a benefit crystallisation event occurs.
Calculating the charge
If you exceed the lifetime allowance the excess fund (referred to as the ‘chargeable amount’) will be subject to a lifetime allowance charge of 55% on any lump sum withdrawn, or 25% on any income withdrawn or on any annuity purchased. In the case of income withdrawals or annuity purchase, this is in addition to income tax at your marginal rate (i.e. currently 20%, 40% or 45%).
|Example (4) Veronica has accumulated a fund of £1,480,000 and decides to take the benefits in 2022/23 when the lifetime allowance is £1,073,100. This means she has an excess fund of £406,900.
Of that excess fund Veronica decides to take £200,000 as a lump sum. The scheme will deduct a 55% lifetime allowance charge of £110,000 from her lump sum, paying her £90,000 net. Veronica has no more tax to pay on that lump sum.
Veronica uses the remaining £206,900 excess fund to provide a pension. The scheme deducts a 25% lifetime allowance charge of £51,725, leaving a net fund of £155,175 which will provide pension income. Veronica must pay tax on her pension income at her marginal rate of income tax.
A basic rate tax payer would usually be better off taking income from any excess over the lifetime allowance as the 25% charge plus 20% tax rate is less than 55%. A higher rate tax payer would normally be free to take either a lump sum or income. This is because although the 25% charge plus 40% tax rate on income is 65% this is effectively reduced to 55% because 25% of the income would normally be tax free.
An additional rate tax payer would usually be better off taking a lump sum. This is because the 25% charge plus 45% tax rate on income is 70% and this is effectively only reduced to 58.75% because 25% of the income would normally be tax free..
Calculation of Lifetime Allowance on Death
If you have a money purchase pension scheme and die under the age of 75, the benefits are not subject to income tax if paid to your beneficiaries within two years. This will prompt a benefit crystallisation event if benefits are uncrystallised and the proceeds are paid as a lump sum, as drawdown, or as an annuity.
There is no benefit crystallisation event for benefits already in drawdown or being paid as an annuity.
If benefits are not paid within two years, they become subject to income tax in the hands of the recipient(s) but there is no benefit crystallisation event.
For defined benefit arrangements, any lump sums are assessed against the lifetime allowance, but there is no benefit crystallisation event for any dependant’s pension. Instead, it is taxed as income for the recipient.
There is no benefit crystallisation event on your death after age 75 as this will have already taken place when you reached age 75.
If you are likely to exceed the Lifetime Allowance
If you are likely to exceed the lifetime allowance you will naturally be concerned about making further pension contributions. In deciding whether to continue contributing to your pension you need to bear in mind:
1) The lifetime allowance could be increased above the rate of inflation at some future date and then it might be too late for you to add sufficient additional pension contributions. On the other hand this may be unlikely in the near future as the Chancellor is looking for ways to increase the tax revenue following the Covid pandemic.
2) There is an old adage that ‘the tax tail should not wag the investment dog’. In other words your decision should be based on how much income you will need once you stop working and not simply on trying to avoid paying tax.
3) If your employer is also contributing to your pension, do you want to lose those pension contributions by leaving the scheme even if you have to suffer tax on them? After all, what really matters is the amount of pension you actually receive after tax. For example, it may be better to benefit from ongoing employer contributions to a pension and achieve, say, a £1.5m pension pot against which a tax charge will be applied, than to stop employer contributions and limit the pension pot to £1.05m to avoid the tax charge.
4) Your employer may be prepared to redirect the company pension contribution into an ISA or some other form of investment for you instead, or simply provide additional salary in lieu of a pension contribution. It is worth finding out what might be on offer, although none of these alternatives will be as tax advantageous for your employer.
5) It may make sense to carry on contributing to your pension if you intend to leave it as a legacy when you die. If the pension pot exceeds your lifetime allowance, then your beneficiaries will have to pay the lifetime allowance charge but they could be saving 40% inheritance tax as the pension fund would be treated as being outside of your estate for inheritance tax purposes. It is also worth noting that the pension fund a beneficiary receives from your pension does not count towards their own lifetime allowance.
Alternatives to continuing to build up your pension benefits
1) If you are married, in a civil partnership, or otherwise in a long term stable relationship you could direct your personal pension funding to that of your spouse or partner. It is good financial planning to build up your spouse or partner’s pension funding. Your spouse or partner can make pension contributions of up to the value of their earnings from employment or self employment, or £40,000, whichever is lower. Even if your spouse or partner is not a tax payer they can still contribute £2,880 a year, which the government will top up to £3,600.
2) If you are not already making full use of your annual ISA allowance and that of your spouse or partner you could direct your personal pension funding to that. ISAs are an excellent alternative for providing additional income in retirement. You will not receive tax relief on your investment into your ISA but neither will you have to pay tax on the income you receive from them. As with a pension fund there is no tax on capital gains (assuming you use a Stocks and Shares ISA) or on any dividend income or interest produced within the ISA fund.
3) If you are prepared to invest some of the money that would have gone into your pension fund into Venture Capital Trusts (VCTs) you will find that they have all the benefits of a Stocks and Shares ISA but with tax relief of 30% (irrespective of your personal tax rate) on each investment. There is a high risk to capital with VCTs as they invest in small, unlisted companies so they will not be suitable for the majority of investors. The risk can be mitigated somewhat by investing in a different VCT each year. They can provide a reasonable level of tax free income once your VCT portfolio has been left for some years to mature.
4) An Enterprise Investment Scheme (EIS) provides similar benefits to a VCT but with the added bonus of the investment being outside of your estate for Inheritance Tax purposes. An Enterprise Investment Scheme can also be used to defer a capital gains tax bill occurred elsewhere. They are even higher risk than VCTs however and so unless you need the additional benefits a portfolio of VCTs is a better choice.
Links to more information
- Pension planning
- Death benefits from pension schemes
- How do ISAs and pensions compare?
- Occupational pensions
- Older pension contracts
- Pensions for women
- Personal pensions
- State pensions
- Uncertain about how to take your pension?
- Starting a pension if you are self employed
- Money Advice Service notes on the Lifetime Allowance
- If you need personal financial advice on the Lifetime Allowance then I am happy to introduce you to Flying Colours Life who have access to independent financial advisers throughout the UK
This information does not constitute personal advice and should not be treated as a substitute for specific advice based on your circumstances.
Information given relating to tax legislation is based on my understanding of legislation and practice currently in force. Whilst I believe my interpretation of current law and practice to be correct in these areas, I cannot be responsible for the effects of any future legislation or any change in interpretation or treatment. In particular you are warned that levels of tax and tax reliefs are subject to alteration and, in any case, the value of such reliefs and benefits may depend on an individual’s circumstances.
If you are in any doubt as to whether any course of action is suitable for you, then you should discuss the matter with a suitably qualified independent financial adviser or other specialist.