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"Oblivious" middle earners face eye-watering pension tax bills

Find out if you're on track for a massive tax bill on your pension with our lifetime allowance calculator.
April 30, 2013

If you've got an old defined-benefit (DB) pension worth £20,000 a year and you've been topping up another pension pot on the side, you might assume you're safe from the eye-watering tax regimes the government use to ravage big pension pots. But new Investors Chronicle data reveals that you could very well be wrong.

Thousands of savers expecting medium-sized incomes from deferred defined-benefit (DB) pensions are on track for a costly shock when they reach retirement. If their savings are left unchecked many of them will exceed the recently reduced lifetime pension limit of £1,25m, and consequently be slapped with tax bills ranging from a few thousand pounds to millions of pounds at retirement.

HMRC says at least 30,000 individuals are expected to have pension assets more than £1.25 milion in the 2014/15 tax year. The sour twist for people with these 'gold-plated' pensions will sting those who are oblivious to how fast their pension pots are growing and continue saving so they exceed the threshold, which, once used up, leaves savers exposed to a brutal 55 per cent unauthorised payment charge.

The numbers show a 40-year-old expecting a £20,000-a-year DB pension, would only have to save another £10,000 a year into well-performing pension investments (returning 7.5 per cent a year) until he retires, aged 65, to bust the limit. In this situation he would face an irreversible 55 per cent tax on over a quarter of a million pounds of his pension (£252,598).

So why are pensions growing so fast? Inflation and investment returns are bloating pension pots much faster than a lot of people expect. Many DB savers don't realise that, unlike other savings, which grow according to interest rates, the money in their DB pension is in fact bouncing up at the rate of inflation. Most DB schemes will rise in line with inflation up to 5 per cent, at which they are capped, in an arrangement known as limited price indexation (LPI).

The rule means anyone with a DB scheme worth £20,000 needs to watch their pension pots like a hawk - especially if they have been saving regularly on top of it. If you left employment many years ago but still retain pension rights, then you need to check what that is worth today. A DB pension that was expected to pay out £20,000 a year 20 years ago, in 1993, today counts £700,000 towards the lifetime allowance - as the Inland Revenue multiplies the annual value of DB benefits by 20 when calculating the figure and then adds on inflation. This is a golden rule that exists under the radar of many savers - and one that suddenly makes the lifetime cap of £1.25m sound much less generous.

And with a number of economists warning that inflation is to rise from 2.8 per cent to over 3 per cent this year, pots could pile on the pounds faster than ever meaning savers now in their 40s and 50s will need to watch their pension pots like hawks to ensure they don't run into trouble.

David Collinson, co-head of business origination at Pensions Corporation, warned anyone who has consistently earned over £40,000 and paid into a DB scheme could be vulnerable to exceeding the lifetime limit. He says the effect of inflation on DB pensions, combined with growth from investment returns on defined contribution and self-invested personal pensions will push thousands of people over the limit without them realising.

And Chris Aitken, financial planner at Investec Wealth Management said a large pension pot left unchecked for just a few years could have grown by "shocking" amounts. He said: "Civil servants, teachers, MPs, senior police officers, senior managers and doctors could all find themselves in danger of exceeding the limit - and they should take financial advice if they want to be on the safe side."

 

Protect yourself against the lifetime pensions limit

The lifetime allowance gradually increased to £1.8m by 2010-11, but from 6 April 2012 the government decided to cut it back to £1.5m. A new form of protection called 'fixed protection' was introduced to protect those who had built up pension pots of more than £1.5m, but no more than £1.8m.

And from 6 April 2014, the lifetime allowance will be further chopped to £1.25m. A new form of protection called 'fixed protection 2014' is being introduced to protect those who have built up pension pots of more than £1.25m, but no more than £1.5m. You will be able to apply for fixed protection 2014 from August 2013.

Phil Bray, a spokesperson at Investment Sense, said: "If you're approaching the lifetime limit, make sure you understand the protections and then apply for them. One thing to be careful of is that once you've applied for protection, you can't make any further contributions to your pension as it will invalidate that protection and you will be left with the massive tax bill you wanted to avoid in the first place."

Visit www.hmrc.gov.uk/pensionschemes for more information.

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