If you have a big pension then pay attention if you want to avoid a fat tax bill. In April 2014 the lifetime pensions allowance is getting a haircut. HMRC says at least 30,000 individuals are on track to bust it in the 2014/15 tax year alone - and among these will be middle earners with generous pension arrangements.
Investors Chronicle has received a steady stream of letters from readers concerned about how the new allowance will affect them, and what they should do to protect themselves. So, here we provide the answers to several questions. We aim to help you avoid waking up one day to find the taxman helping himself to your hard-earned retirement savings.
What is the lifetime allowance and what does it include?
The 'lifetime allowance' is a cap that puts a ceiling on the amount you're allowed to save into a pension before it is subject to 55 per cent tax. It applies to your entire pension savings, including your 25 per cent tax free cash, but it doesn't include any state pension you may be entitled to. From April next year the lifetime allowance is being reduced from £1.5m to £1.25m, meaning anything you accumulate above this will be taxed at 55 per cent.
I've got several pension pots. How do I work out if I'm over the limit?
Most people don't just have one pension pot, so this is a common question. If you've worked for several different companies during your life it's likely you'll have a number of workplace schemes, and quite possibly a combination of defined benefit (DB) (where your retirement income is pre-decided) and defined contribution (DC) pensions (where your retirement income depends on how the money invested has performed). And you might have set up a self-invested personal pension (Sipp) as well. To work out whether you're close to or over the Lifetime Allowance, you need to calculate the total value of all your pensions.
Working out the current value of your Sipp is quite straightforward as you can see the total value of your investments when you have a look at them, although if you're invested in risky assets this could vary drastically from one month to the next, so that's worth bearing in mind. And DC schemes are relatively easy to value, too – you can just call up the employer or the company that manages the pension and ask how much the fund is worth. But when it comes to working out the value of DB schemes, it gets a bit trickier.
How do I value 'gold-plated' or DB pensions?
Your DB pension could be rising in value faster than you realise. This is because unlike other savings, which grow according to interest rates, the money in your 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 Inland Revenue multiplies the annual value of DB benefits (that's the amount you're due to receive every year in retirement) by 20 and then adds on any tax free cash you might be due to get the total value. And this is what you need to do to work out how much of your Lifetime Allowance your DB scheme has used up.
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. For example, someone on track for a DB pension of £50,000 and a lump sum of £250,000 would reach the new lifetime limit. Also, 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. And with a number of economists warning that inflation is to rise from 2.8 per cent to more than 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 monitor their pension pots to ensure they don't run into trouble.
How can I protect myself from busting the limit and paying too much tax?
If you will have between £1.25m and £1.5m at the end of the next tax year (5 April 2014), applying to HMRC for Individual Protection 2014 (IP14) will protect you from the lifetime allowance charge. If your fund is worth more than £1.5m you can apply, but IP14 will be capped at £1.5m. Applications are expected to open from April 2014, but no matter when you apply for it the value used will be that at 5 April 2014. Once you've got it, you can continue to accrue future pension benefits without losing entitlement to the protection, but any pension savings in excess of your lifetime allowance will be subject to a lifetime allowance charge.
It is possible to protect the growth of your fund, too, on a fund worth up to £1.5m. You can do this by getting Fixed Protection 2014 (FP14), but this prevents you from being able to make any further pension contributions. You'll have to apply for this before April 2014. And watch out if you're already registered for Enhanced or Primary protection in previous years, as your application will be rejected. But Greg Kingston, head of marketing and proposition at Suffolk Life, says if you plan ahead, it is possible to contribute a significant amount in advance of applying for fixed protection 2014 by clever use of pension input periods and carry forward. You can contribute a maximum of £50,000 for the year 2013-14, and £40,000 for the year 2014-15 as explained in the diagram below.
Do you want to see how much money individual and fixed protection could prevent you losing? Our Lifetime Allowance calculator below will show you…
