How can I manage my lifetime allowance?

Pensions are always in the firing line when it comes to tax grabs, with regular adjustments to the allowances, tapers and rates that control the exact amount of tax relief we all get. These include the lifetime allowance (LTA) – the amount you can build up in your pension pot over your lifetime before having to pay a penalty tax – which has been cut over the years from a high of £1.8m to just over £1.073m for the 2020-21 tax year.  

Now Rishi Sunak has announced that the pensions lifetime allowance is to be frozen at £1.073m until 2026, exposing more savers to the charge for breaching the threshold.

Those who breach the threshold face a 55 per cent charge on amounts taken above this ceiling if this is withdrawn as a lump sum, with the charge falling to 25 per cent if this is taken as income.

Deciding not to increase the allowance in line with inflation can be particularly punishing for groups with generous workplace pension arrangements. Gareth Jenkins, head of life product and inforce at insurer Zurich, described the allowance freeze as “nothing less than a tax on growth”, adding: “This will hit people on middle incomes who save hard or invest wisely, including NHS doctors and headteachers.”

As with all taxes, it is important to understand how the LTA is applied so that you can avoid actions that will cost you unnecessary tax.

How does the LTA apply?

The LTA applies to the value of all your pensions savings, and many investors are wary of getting too close to the LTA limit because they believe they will be forced to pay a hefty tax bill there and then, says Kay Ingram, director of public policy at LEBC Group. “But this isn’t the case. The LTA is a cumulative allowance, which means you don’t have to pay tax until you exceed it, and only then when a test of your pension pot takes place.”

Your pension pot will only be tested against the LTA at what are called benefit crystallisation events (BCEs). There are 13 of these (see https://www.gov.uk/hmrc-internal-manuals/pensions-tax-manual/ptm088100#IDAX15K). The main ones are when you first start drawing a pension, when you reach age 75 and when you die. “There’s no question that your fund will be tested against the LTA at some point as at least one of those events is going to happen,” says Martin Reynard, senior pensions manager at Blick Rothenberg.

If you take your pension benefits in stages, or if you access a second or third plan, you will be tested each time you do this. Each event will use up a percentage of the LTA. For example, if you have a self-invested personal pension (Sipp) worth £90,000 and a workplace pension worth £500,000, and you crystallise the Sipp first, this will use up 8.38 per cent of your LTA. At every BCE you will be given a certificate stating how much of the LTA you have used.

When all your LTA has been used up, any excess funds being accessed will suffer a lifetime allowance charge (LAC). This is a one-off tax charge of either 55 per cent if you take the excess fund as a lump sum, or 25 per cent if you take it as income. Only the excess above the LTA is taxed. The pension administrator will deduct the tax.

You can work out whether you are at risk of incurring a charge by adding up the value of all your pension pots. For defined-contribution (DC) pots and Sipps, you use the value of the fund. For defined-benefit (DB) schemes, the value is 20 times your starting pension income plus any lump sum paid to you. For example, if you have a DC pension fund of £215,000 and a DB pension that will pay you £56,000 with no lump sum, your pension funds would have a total value of £1,335,000, which is £261,900 above the current LTA. A lump sum would increase this excess. The state pension does not count towards your LTA.

Once you have used up all your LTA, all future pension pots accessed will result in an LAC as there will be no LTA to use against these. And you can only take tax-free cash up to the value of the LTA unless you have protection, in which case it’s 25 per cent of your enhanced LTA (see more on protection below).

With a DB pension, the scheme will pay any tax due on the excess and an actuarial adjustment will be made resulting in a reduced pension income. Any tax-free lump sum will be added to the value of your pension, but will be paid to you and in such a scenario a bigger adjustment would be made to your pension income, says Mr Reynard. 

The test at age 75

Even if you sail through the test when you first move funds into drawdown, you will face a further test at 75. This test will take in the value of all your uncrystallised pension funds and any gains made on crystallised funds in drawdown. “Drawdown funds are tested at age 75 regardless of whether there are other uncrystallised funds or not,” says Mr Reynard. “This can catch people out and they are surprised when they get a tax bill at 75.”

Funds crystallised pre-age 75 which were close to the LTA cap are likely to have gains that exceed the cap. Because withdrawn funds are not counted, if you intend taking out the money for yourself anyway then “it could be worth accelerating your income withdrawals before age 75”, says Ms Ingram.

For example, let's say at the age of 65 you crystallise a pension pot, taking 25 per cent tax-free cash and putting the rest into drawdown, actions which use up all of your LTA and result in a small LAC. At age 75 there will be a further test – this time of the increase in your drawdown funds from the first crystallisation.

If the funds in your pot have grown by £400,000 you will have to pay a tax charge of £100,000 (£400k x 25 per cent). If you had withdrawn £150,000 more in income during the 10-year period you would have faced an age-75 tax charge on £250,000 instead. But you would also have had to pay income tax on the withdrawals.

What to do if you are near the LTA threshold

Most advisers will tell you that is it better to keep saving into a pension rather than worrying about a potential tax charge. Money invested in a pension rolls up free of tax – there is no income tax or capital gains tax (CGT) to pay while it is invested – which should boost your returns. You may not get all of the growth above the cap, but you will get 45 per cent of it. If you cease making contributions you may have to give up employer contributions, and missing out on generous ones is financially worse than paying tax on any excess.

Pensions also have a role to play in inheritance tax (IHT) planning (See 'Passing your pension on', below). “Your beneficiaries can inherit your pension fund and it won’t be subject to IHT or count towards their lifetime allowance,” says Ms Ingram. “Someone with an untested pension fund worth £1.2m at age 75 would have to pay tax at that point on the excess amount. But in return you will be able to pass on the remaining fund on death to your children free of IHT, which is charged at 40 per cent, and all growth and income in the pension pot beyond the age of 75 is tax-free.” 

After the age of 75 your funds will not be tested again. “If someone has a fund of £1m – just under the current LTA – at age 75, when they complete the test and they, for example, live for another 15 years during which time the fund grows to £2m, there would be no LAC to pay because the LTA is irrelevant after 75,” says Ms Ingram. “So if you have other sources of income and can avoid accessing the fund, consider doing that. For all the time your money is in the pension fund, it is growing free of income tax and CGT. Most advisers would say always draw your pension last.”

However, if you intend living off your fund rather than passing it on you should weigh up your options. “If you are the only one funding your pension and there are no generous employer contributions, consider stopping payments because you are only really at best looking at 20, 40 or 45 per cent relief on your contributions, but certain of paying 55 per cent when the money comes out,” says Mr Reynard.

Instead, you could maximise contributions to other tax-efficient vehicles such as individual savings accounts (Isas) to draw on in later life.

Should you pay 55 per cent or 25 per cent?

Choosing between which tax rate to pay depends on what you intend to do with the money and your tax status. If you plan to withdraw the money later, then you need to factor in the income tax you will pay on top, because pensions are taxed as income. Additional-rate taxpayers will pay less tax if they take excess funds as a lump sum – 55 per cent tax – rather than as income. “The maths of it is such that additional and higher-rate taxpayers paying 25 per cent on day one, and then income tax on withdrawals, would effectively be charged at least the 55 per cent they were avoiding in the first place,” says Mr Reynard.

Against this is the fact that funds left in drawdown grow tax-free.

Level of tax on a £10,000 excess

Source: HMRC, IC

To DB or not to DB?

If you have both DB and DC pensions, consider carefully which pension you take first. The way these two types of pensions are treated is not equal and DB scheme members can get a lot more pension for their LTA than someone in a DC scheme. For example, you can receive an income of £53,655 and a lot of additional benefits from a DB scheme without having to worry about the current LTA. But a fund worth £1,073,100 in a DC scheme would yield a much lower level of sustainable income.

If your DB pension takes you over the LTA, the pension scheme will pay the tax charge for you and make an actuarial adjustment to your pension income. “It’s usually quite appealing if there is a DB scheme in the mix to make the DB pension the one that pays the tax charge because while it reduces the pension, it is usually at a good mathematical factor,” says Mr Reynard. “And why would you want to reduce the DC pot that gives you the greatest flexibility in order to pay a tax charge, when you can simply reduce the inflexible pension?”

To ensure that the DB scheme is the one that triggers the charge you would first need to crystallise your DC pots.

For some investors, however, the priority will be to secure the highest possible amount of guaranteed pension income particularly if they are in good health and have a dependent spouse.

Furthermore, if you have no allowance left, and are due to receive a DB pension, it could be worth considering transferring out to a personal pension before you take that income, as doing so could result in a far higher net amount. “A person entitled to a DB pension of, say, £30,000 who has used up 100 per cent of the LTA would face a significant reduction in that income as the scheme would pay the tax but actuarially reduce the pension payable," says Ms Ingram. "They should compare the value of a cash transfer, less the LAC, with the reduced pension quote.”

She adds that if the DB excess is small then it’s not worth sacrificing the guaranteed benefits you would get. 

If you have small pots with a value of less than £10,000, these do not count towards the LTA, as long as their owner still has some LTA to use, so anyone "likely to exceed the LTA should consider drawing on these prior to using up the allowance," says Ms Ingram. "They could save up to £16,500 in tax by doing so.”   

What protection is on offer?

It has previously been possible to lock into a much higher rate of LTA, typically when the allowance was being cut, but with the proviso that no further contributions could be made. If they were then the protection would be lost. “To secure the protection you had to pull out of the UK pension system,” says Mr Reynard. However the advantages of claiming the earlier protections were that you get a higher LTA and a higher tax-free cash limit.

Only two forms of these types of personalised protection are now still available, one of which permits post-April 16 contributions to be made. These are Individual Protection (IP) 16 and Fixed Protection (FP) 16.

With IP16 you can use an LTA of up to £1.25m and you can apply for this protection if you had a fund worth at least £1m at 5 April 2016.  Under IP16 you can continue to make your own contributions and receive employer contributions which makes it particularly attractive for employees in a defined-benefit scheme.

FP16 also offers £1.25m of protection – even if your pension funds were below £1m at 5 April 2016 – ­providing you have not made any further contributions since 6 April 2016. Using these protections means you could save more than £97,000 in tax compared with an LTA of £1,073,100, says Ms Ingram.

“IP16 is a useful tool for someone who is in an employer’s scheme and does not want to turn down an employer’s payments," says Mr Reynard. "You should think twice before you transfer out of a good quality final-salary scheme, particularly if there is no cash alternative on offer. It’s usually better to stay in the scheme, with all its benefits. For example, you wouldn’t want to rush out of the NHS pension scheme.

Passing your pension on 

DC pensions are very useful when it comes to inheritance tax planning. “What the 2015 legislation did in effect was to create a trust in perpetuity,” says Kay Ingram. That’s because not only can DC pension pots be passed down free of inheritance tax and even free of all tax, they can also be passed down by your heirs to the next generation too. Pensions funds that are inherited by your beneficiaries do not count towards their own LTA.

For anyone with alternative sources of income and who can therefore afford to leave some or all of their pension fund untouched, passing on a pension pot can be a very tax-efficient means of leaving a legacy, even where the funds in question exceed the LTA and LAC charges arise.

By using up other savings the individual will maximise the amount of their pension pot that can be passed down IHT-free (which meanwhile is growing within a tax-free wrapper) while at the same time shrinking the size of their non-pension wealth which will help to reduce or prevent an IHT charge on that.

Your pension pot will still have to be tested against your LTA, either before you die or at your death. How your funds are taxed and who is responsible for paying the LAC if it applies depends on what age you are when you die, and what you have done with your pension funds.

If you die before age 75, your uncrystallised funds will be paid to your beneficiaries and tested at that point against the LTA. Funds that have been crystallised will also be paid to your beneficiaries but they will not be subject to an LTA test. In this situation – that your death happens before you reach 75 - your beneficiaries will not have to pay income tax on inherited pensions and they can withdraw the money as a lump sum, or as income. However this is all conditional on the funds being designated to your beneficiaries within two years of your death otherwise the lump sum option will not be tax-free.

If there is a tax charge on the uncrystallised funds following the LTA test, your heirs will be responsible for paying the charge not the pension provider. They can choose between a lump sum or income option on the excess funds, paying 55 or 25 per cent as appropriate.   

If you die after age 75 funds being passed to beneficiaries will not be subject to an LTA test. But the beneficiaries will pay income tax at their marginal rate as they withdraw funds. Depending on the size of the pot, income streams and lump sums from the inherited funds could result in them paying a much higher rate of income tax. Your beneficiaries will not be allowed to take a 25 per cent tax-free sum even if you have not done this.

Depending on the scheme or Sipp plan your funds are in, your beneficiaries may be able to choose how to invest the funds in drawdown.Note that other restrictions may apply too to older style pensions.