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Did you know there is a limit to how much you can save into a pension? This is called the Lifetime Allowance, and in 2021-22 this currently stands at £1,073,100. Whilst this may sound like a lot (especially to younger savers), it often catches people by surprise as they approach retirement. Without careful planning, exceeding this threshold could result in punitive tax charges which could significantly erode your savings.
In this guide, our financial planners outline how the Lifetime Allowance works and suggest ways to navigate it effectively. We hope you find this content useful. If you want to discuss your own financial plan with us, please contact our team for more information or to access personalised financial advice:
020 8366 4400 or enquiries@cedarhfs.co.uk
Understanding the Lifetime Allowance
The Lifetime Allowance was introduced primarily to stop people abusing the generous tax reliefs offered by pension rules. Remember, anything you save into a pension is “topped up” by the UK government according to your highest rate of income tax. So, a Basic Rate taxpayer receives a 20% “boost” to his/her contributions (instead of paying tax on the contribution), whilst a Higher Rate taxpayer receives 40%.
You do not “use” any of your Lifetime Allowance until you start taking benefits from your pension – e.g. as a lump sum, or as income. At this point, a “benefit crystallisation event” occurs and this goes towards your Lifetime Allowance. For instance, suppose you have £1m saved in a pension and you take out £50,000 as a lump sum. This would create a benefit crystallisation event and leave you with £1,023,100 left in your Lifetime Allowance to use. If you then took another lump sum out, this would create another event and use up more of your allowance.
What happens if I exceed the Lifetime Allowance?
Turning 75 is another point where a benefit crystallisation event takes place – even if you have not yet accessed your pension(s). Other things that can trigger an event include death and transferring your benefits to a qualifying recognised overseas pension scheme (QROPS).
If you exceed your Lifetime Allowance, however, then a 55% tax charge is levied on any lump sums you take out. Any pension income taken after this point is subject to 25% tax. The scheme administrators should deduct any charge on your behalf and permanently reduce your benefits.
How do I keep within the Lifetime Allowance?
Doing this on your own is more difficult than it sounds. First of all, the Lifetime Allowance has varied over time. When it was introduced in 2006, for instance, the limit was £1.5m. Over the years, however, it has steadily come down. Secondly, it is challenging to project where your retirement savings will stand in the future without financial planning experience and software. How much can you expect your investments to grow, and how much might you need? These are important questions requiring informed answers.
Calculations are even more difficult if you have a “defined benefit” or “final salary” pension plan. Here, you do not have a “pot” of money which you have saved up for retirement. Rather, your employer pays you a guaranteed lifetime income in retirement (e.g. based on your average salary and years of service). Here, you should consider professional financial advice to help you ascertain how your scheme may impact your Lifetime Allowance (LTA).
There are some strategies to help mitigate a future LTA charge. First of all, fixed protection 2016 may allow you to “extend” your LTA if the value of your pension(s) was above the new threshold at the time of the 2014 and 2016 budgets. You can only apply for this protection if you have not made any pension contributions since the 5th April 2016.
Another possible route is individual protection 2016. Here, you can apply for a “personalised” LTA which equals the value of your pension(s) on the 5th April 2016 (provided they were worth over £1m). The maximum LTA you can apply for is £1.25m. This option allows you to keep on making further pension contributions, although they are likely to be taxed.
For those who are nearing their LTA limit, you may wish to consider using an ISA for further retirement savings. Here, you can put up to £20,000 into, say, a stocks & shares ISA and any interest, capital gains and dividends will be tax-free. For those aged between 18 and 40, you could also consider opening a Lifetime ISA (LISA) and you can put up to £4,000 into it each year until you are 60. The UK government will add 25% to anything you contribute up to a maximum of £1,000 each tax year.
Finally, remember you are still entitled to various tax allowances each year – even into your retirement. You can use these strategically alongside other tax-efficient savings/investment vehicles, like your ISA. For instance, each year you can generate up to £12,300 in capital gains within a general investment account without these getting taxed. You can also receive up to £2,000 in dividends each year, tax-free.
Conclusion
Interested in discussing your financial plan with an experienced financial adviser? Get in touch today to discuss your financial plan with a member of our team here at Cedar House via a free, no-commitment consultation:
020 8366 4400 or enquiries@cedarhfs.co.uk