Understanding the Lifetime Allowance

Jul 25, 2022 | Pension Transfers, Pensions, Retirement, Tax

Most retirees are aware of the Lifetime Allowance – a limit on the total amount of money that can be saved in pension schemes before incurring a tax charge. However, many people are unsure of how it works or what they need to do to stay below the allowable limit. In this article, we will provide an overview of the Lifetime Allowance and explain how you can protect yourself from exceeding it.

If your pension pot’s worth more than £1.073 million, you’ll want to be aware of the punitive taxes that could be levied against you when you retire.

Protect Your Funds

The government has used tax breaks to encourage those who are saving and preparing for retirement. However, limits have been set on how high your retirement funds can grow. You could end up paying 55% in taxes if the value of your account breaches an upper limit known as the pensions Lifetime Allowance (LTA). Knowing this early on can help you save in more tax-efficient ways.

How Much Can I Save Before Extra Tax Charges?

The LTA limit has been reduced and frozen several times, but there is a lot of discussion about limiting this even further. According to a leaked proposal, the Autumn Budget on October 27 will cut it from just over £1.073m to around £800,000. If withdrawn as a lump sum, funds above this threshold would be taxed at 55%, and if paid as income, 25%. With this new legislation, more and more savers will be drawn into the LTA net.

When the cap was first introduced in 2006, it was set at £1.5 million – an amount which did not change until 2010 when it increased to £1.8 million.  In 2016 tax threshold dropped down to £1m and has since risen in line with inflation, to £1.073m which is now frozen at this limit until 2025/26.

How Can I Calculate Whether I’m Likely to Breach The LTA?

The LTA at retirement can be calculated by taking the amount of pension income that you would expect from a DB scheme and multiplying it by 20. This will give your notional “pot” value. It’s more difficult for DC schemes as there are 13 different ways your pension could be tested against the LTA which can include buying an annuity, taking drawdown and even when you die.

Many people have likely worked across both the private and public sectors during their careers, which can make it difficult to determine if they’ll have an issue with the LTA.

It would be necessary to contact the administrator of each pension plan for each employer with which you have previously worked and to ask them to provide an illustrated value of the benefits, and then apply some complex math, which depends on assumptions about investment growth and inflation.

Hiring a qualified professional can help you avoid huge tax penalties. You may be able to save thousands in the long run by working with an expert who will take care of all these things instead!

Paying The LTA Charge?

Except for the State Pension, the LTA applies to the value of all your pensions. The LTA charge applies only to funds that exceed the limit, not the entire fund.

When certain conditions are met, the LTA charge is applicable. Firstly, if you die before you turn 75 and you have not accessed your funds in any way. Secondly, if you reach age 75 and haven’t accessed your funds or if they are in pension drawdown. Third, if you decide to withdraw benefits from your pension, either as a tax-free lump sum, a regular sum or as a pension drawdown. Lastly, if you transfer your pension funds overseas.

You may want to seek financial advice if you’re not sure what your next steps are in this area.

Lower The Risk of Breaching The LTA

Mitigating the size of tax penalties is often about making changes to how much money you save into a pension versus other savings products, such as GIAs or offshore bonds. Alternatively, it could involve changing your investment strategy or timing issues with retirement plans- these are complex considerations unique to each individual’s circumstances.

It could be that you’re on or close to the threshold and should consider whether it makes sense to divert some savings, such as a GIA. This is because there are penalties of up 55% if one breaches this limit with withdrawals

It isn’t always the right thing to avoid going over the LTA.

If you are considering a course of action which could mean losing out on employer contributions to your DC pension arrangement, those in DB schemes may be better off building up their retirement benefits and paying the LTA charges. However, it is important that each person’s personal financial circumstances differ so you should take professional advice.

Because investment performance cannot be predicted, it is difficult to protect against LTA in a DB scheme; retiring early, therefore, ensures the calculation basis is fixed for the future. The issues surrounding this are complex, but it is clear that the taxes imposed by an LTA charge may actually offset any savings from lower employee contributions.

Can You Protect Yourself?

If you think your pension fund might breach the LTA, don’t worry. There are two types of protection: Fixed Protection 2016 and Individual Protection 2016 which you can apply for through HMRC

Fixed Protection 2016 will allow you to fix your LTA at £1.25m, provided that no further contributions can be made into the pension scheme.

Individual Protection 2016 is for individuals whose pensions were worth over £1.25m when the LTA was reduced on 5th April 2016. You can continue to contribute to your pension but must pay tax on money taken from your pension savings that exceed your protected lifetime allowance.

If you are nearing retirement and are unsure of how the Lifetime Allowance works, or if you want to take steps to protect yourself from exceeding it, please get in touch with SJB. We can help you understand the allowance and advise you on the best way to stay below it. Our team of experts will be happy to answer any questions you have and provide guidance on what steps need to be taken to ensure a comfortable retirement.

This communication is for informational purposes only based on our understanding of current legislation and practices which are subject to change and are not intended to constitute, and should not be construed as, investment advice, investment recommendations or investment research. You should seek advice from a professional adviser before embarking on any financial planning activity. Whilst every effort has been made to ensure the information contained in this communication is correct, we are not responsible for any errors or omissions.

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By scheduling an appointment with an adviser they will reach out to you at your requested time. 
Personal advice, whenever it suits you.

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