Although the government wants us to save for retirement, it doesn’t want us to save too much. Thanks to generous tax breaks on pension contributions, the more we pay in, the more it costs the Treasury, and the lifetime allowance (LTA) is one way it caps the amount of money we can save tax-efficiently.
The LTA dropped to £1 million this tax year, down from £1.25 million last year and a much more generous £1.8 million in 2011/12.
Your pension benefits are tested against the lifetime allowance when you start to draw them from the scheme. If your total pension savings exceed the LTA at retirement, you will face a punitive tax charge on the excess. This is 55% if you take the money as a lump sum or 25% if you take it as income. These figures have been set so that the tax paid is broadly the same however you take the money.
The new £1 million limit, which has been in place since 6 April, will clearly affect high earners. But many people who don’t perceive themselves to be particularly wealthy may also be caught out if they have spent a long career in the public sector and have a generous final salary pension. Philip Smith, a director at PwC says: “Police inspectors could get caught out, as well as head teachers, doctors and so on.”
While government figures suggest that only 4% of people will be stung, if you consider that there are around 11.5 million people approaching retirement aged between 50 and 65, at least 460,000 people could be affected.
Gary Smith, a financial planner at Tilney Best Invest, believes the numbers will only increase. It is an underestimate, he says. “It’s difficult to quantify the numbers affected but if you are, say, in your 40s, and paying in £1,000 a month, you’re going to hit the allowance.”
What to do if you think you'll breach the £1 million limit
The first step is to get a pension valuation. If you’re in a defined contribution (DC) scheme, in which your end pension depends on the amount of contributions and how they are invested, look at your annual statement. This should give you a current valuation for transfer purposes and an indication of what it will be worth when you retire.
Members of defined benefit (DB) schemes that provide a pension based on a formula related to your salary, need to take their anticipated pension income (which should be in your paperwork) and multiply that by 20.
So, once you are looking at retiring on an income of £50,000 a year, your pension would be valued around £1 million. But Gary Smith says it’s important to also factor in any lump sums “if they don’t reduce your starting pension,” as offered by the Teachers’ Pensions and NHS schemes, for example.
If you’re still a way off retiring, it’s also important to note that the LTA is likely to rise. Gareth Shaw, head of consumer affairs at Saga Investment Services, says: “From April 2018, it will be rising in line with inflation. Bear this in mind before taking action in other places.”
But Philip Smith questions how beneficial this uplift will be. “You would expect the value of your pension benefits to increase by more than the Consumer Prices Index.”
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Consider the government protections
Recognising it has moved the goalposts, the government does offer a degree of protection for those that have either breached or are approaching the new, lower LTA. This comes in the form of fixed or individual protection 2016 (known as FP16 and IP16).
Fixed protection enables savers to maintain an LTA of £1.25 million and is available to everyone. However, while FP16 is theoretically still available, in order to secure this limit savers are not able to make any further contributions after 5 April 2016. If you have paid in money since this date, you will no longer be eligible.
Individual protection, meanwhile, is available to those whose pension benefits exceeded £1 million at the end of the tax year on 5 April, but want to continue contributing. Gary Smith explains: “For those who qualify, their LTA will be set at the value of their pension benefits on 5 April 2016, subject to a maximum of £1.25 million. Unlike fixed protection, those who apply for individual protection will be able to continue to make pension funding in the future.
Angela Murfitt, a chartered financial planner at Fairstone Financial Management, says the decision on whether to apply for IP16 is fairly black and white. “If an individual had a fund in excess of £1 million on 5 April 2016 and did not hold any existing protections, it is likely that IP16 will be appropriate – there are no restrictions on making further pension contributions, so there is no downside of applying for the protection if it is available.”
The government is expected to allow savers to apply for protection online from July (the legislation is yet to receive Royal Ascent). However, Gary Smith says you should register your interest ahead of this date. “This will benefit those individuals who intend to retire prior to July,” he says, “but we would also strongly encourage all those who don’t intend to retire during this period to register their intention with HMRC as soon as possible. This means that should the unthinkable happen and the individual dies, it will offer the individual protection.”
Patrick Connolly, a chartered financial planner at IFA Chase de Vere, adds that it’s still possible to apply for protection introduced for previous LTA reductions. “Some people may also still be eligible to apply for individual protection 2014,” he says. “This would apply to those with pension funds valued at more than £1.25 million on 5 April 2014 and can provide a lifetime allowance up to a maximum of £1.5 million.
Other ways to save for retirement
Once you have reached the LTA, there are other ways to save tax effectively. The obvious starting point is an individual savings account (Isa).
Mr Shaw says: “You will be losing tax relief on your contributions, but when you come to take the money out it will be paid tax-free. This can be very helpful when planning your income in retirement.”
Following a rule change that allows savers to pass on money in pensions to their heirs free of inheritance tax (IHT), there is a greater incentive to draw some retirement income from vehicles other than your pension.
This tax year you can invest £20,000 into an Isa, while a couple between themselves can shelter £40,000 tax free.
- Find the best stocks and shares Isa using our comparison tool.
Those who have already exhausted their Isa allowances could consider a venture capital trust (VCT) or enterprise investment scheme (EIS).
VCTs provide finance for small UK businesses. To encourage investors, the government offers a 30% income tax rebate on your investment so long as you remain invested for five years. At this point, you can sell your VCT without incurring capital gains tax on any profits.
EISs also invest in smaller companies but unlike VCTs are not listed on the London Stock Exchange. They offer similar tax breaks, but the required holding period is three years.
But you could end up seriously out of pocket with these investments. Mr Shaw warns: “They can be attractive, but they are very much long-term investments and are often invested in start-up companies.”
Topping up your spouse’s pension may also be an option. Putting money away for a non-earning spouse gets you tax relief on the way in. If the income in retirement is less than the personal allowance, it may mean no tax is paid on the way out either.
Working out what to do will depend on whether you’re paying into a DC or DB scheme, what your earnings are, and how your employer pays into your pension, to name just a few of the many considerations you will need to make before you opt out of your pension.
Mr Cox says: “There is no one-size-fits-all solution. If you are close to retirement, you could quit the scheme, apply for protection and get your employer to pay its contributions as salary or bonus to avoid the tax charge.”
Should you retire early?
Some people in final salary schemes may use the lifetime allowance as an excuse to retire early. Gary Smith says members can typically expect to see their annual income reduce by 5% for every year they knock off their working life. “Retiring early is a legitimate planning tool,” he says.
But while you may get the benefit of quitting work early, there are risks to consider such as the solvency of your employer. Philip Smith says: “You only get full protection from the Pension Protection Fund if you retire at your normal retirement age.”
Opting out of your pension scheme may make less sense if you have many years before you retire. However tough a 55% tax charge might be to swallow, some advisers point out that it might be worth accumulating a bigger pension and simply paying the charge – particularly if you’re a higher-rate taxpayer and your employer makes generous contributions on your behalf.
Mr Connolly says: “It would be far better to benefit from ongoing employer contributions or achieve good performance and have, say, a £2 million pension pot, on which a tax charge will be applied, than stop employer contributions or not achieve good performance and have a £1.25 million pension with no tax charge.”
Philip Smith points out that in a DC scheme a higher- rate taxpayer could have £200 going into their pension each month at a cost of just £60 to them once tax relief and employer contributions are taken into account. With that £200 rolling up in a pension, getting taxed at 55% at the other end still isn’t that bad a deal,” he says.
Mr Cox says if you are still a way off retiring, the LTA isn’t sufficient reason to exit your pension. “There is always the chance that the LTA could be scrapped and you won’t be able to get back into the scheme,” he explains. “You also won’t get back the true value of your employer’s funding in salary and may miss out death in service benefits and other sickness benefits that may be tied in with the pension scheme.”
Gary Smith says the value of death-in-service benefits – which pay a lump sum if you die before reaching pensionable age – must not be overlooked, particularly if you are not married. “If you have been widowed or are divorced, your kids wouldn’t get anything.”
He spends a lot of time advising clients in the NHS pension scheme and as part of his analysis compares the impact of remaining in the scheme and doing nothing, opting out and applying for fixed protection and remaining in the scheme and applying for individual protection (see table above). “In 90% of cases, opting out is the worst option,” he says.
The situation will be more complicated again if you earn more than £150,000, as you would also have to consider the impact of the tapered annual allowance. This reduces the amount you are able to save into your pension each year from £40,000 down to £10,000 by the time your income reaches £210,000.
Nobody relishes a 55% tax charge and while individual protection may mean you don’t feel the full brunt of cuts to the LTA, it’s best to consult a specialist adviser before you quit your scheme. They will be able to take into account the minutiae of your pension scheme and your wider finances to maximise your retirement income and limit your charges.
Gary Smith adds: “Many pension savers will choose the opt-out option, but this does not necessarily represent the best outcome for them. I would encourage all those who are considering ‘protection’ to seek professional advice, as making the incorrect decision now could significantly impact on their long-term retirement plans”.
- Your guide to final salary pensions.
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The lifetime allowance dilemma: the adviser’s view
Patrick Connolly, a chartered financial planner at Chase De Vere, says: “The challenge from an advice point of view is that if we are concerned about clients breaching the LTA in the future then we could tell them to stop saving, but then the LTA could be scrapped and the client has missed out on additional pension contributions and potentially employer contributions too.
Alternatively, we could tell them to continue with pension contributions but they might get hit with a significant tax bill when they take benefits.The difficulty with making these decisions now is that we can’t even be sure what the pension rules will look like next year, let alone in 10 or 20 years’ time.”
This article was originally published in our sister magazine Moneywise, which ceased publication in August 2020.
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