Beware of The Pension Lifetime Allowance Tax Trap
Are you aware of the pension lifetime allowance limit and how much tax it could cost you? Martin Strutt explains.
The pension lifetime allowance was originally introduced in 2006, as a new limit on the total tax relievable pension benefits you can accrue in your lifetime.
It is currently (2018/19) £1,030,000 and will increase with inflation (measured by the CPI) each year, increasing to £1,055,000 on 6th April 2019. However, it has been reduced from a peak of £1.8 million since 2012.
Despite its complexity, it could be very important for you to understand how this works, because if the value of your pension benefits exceed the lifetime allowance, you will have to pay a tax charge on the excess (up to 55%).
Lifetime allowance is assessed every time you take benefits from a pension scheme. Pension benefit values are compared to your remaining lifetime allowance in order to see if a tax charge is due.
Different types of pension scheme have their pension value calculated in different ways.
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 a defined benefit pension, the value is calculated by multiplying the annual pension by 20 get a capital amount to compare with the lifetime allowance.
Certain other pension benefits (e.g. some lump sums paid to your survivors if you die before age 75) are also assessed against the lifetime allowance.
There’s also a lifetime allowance check made against any unused pension benefits once you reach your 75th birthday.
A new analysis by insurer Royal London has concluded that a significant number of retirees could face a lifetime allowance charge in the future. It estimates that around 290,000 people already have pension benefits exceeding the lifetime allowance. They forecast that over a million people risk breaching the lifetime allowance by the time they retire.
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 (prior to its reductions) and reduce the tax charge paid.
Royal London also found that almost half of the 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 generous contributions from their employer.
Typical salary ranges of those likely to fall into this category are £60,000 to £100,000 a year. Those earning more 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.
The rising number of people likely to exceed the lifetime allowance in the future is also the result of the allowance rising in line with inflation, but wages and pension funds typically rising much faster.
As a result, the lifetime allowance is likely to ‘bite’ progressively more severely over time, affecting hundreds of thousands of people who don’t necessarily think of themselves as wealthy.
There are schemes in place designed to protect your lifetime allowance and other steps you can take to mitigate a potential charge, but before registering for a protected lifetime allowance, or taking other action, it’s essential to seek professional independent financial advice.