Interactive Investor

How to avoid a 55% pension tax bill

23rd June 2022 11:11

Alice Guy from interactive investor

The lifetime allowance means that pension pots over £1,073,100 are hit with 55% tax. Alice Guy looks at how it works, who will pay and if it’s possible to avoid it.

What is the lifetime allowance?

The lifetime allowance is designed to stop people squirrelling away billions in their pension and getting access to millions’ worth of pension tax relief.

It means you’re only allowed to invest a maximum of £1,073,100 in a pension fund before being hit with a 55% tax charge on the excess. The allowance will be frozen at the current rate until at least 2026, pulling thousands more into the tax charge.

The lifetime allowance also applies to people with a defined benefit pension scheme or with both defined benefit and defined contribution pensions.

How does SIPP lifetime allowance work for defined contribution schemes?

The lifetime allowance works by comparing the size of your pension pot to the allowance when you withdraw money from your pension.

For example, if you withdraw £100,000 from your pension, you will use up 9.3% of your lifetime allowance (£100,000 as a percentage of £1,073,100).

Your pension is also tested against the lifetime allowance when you reach 75 years old and if you die with any pension remaining.

You might be surprised to know that you could breach the lifetime allowance without your pension ever reaching £1,073,100. And it’s even possible for someone with a fairly modest pot to accidentally breach the lifetime allowance. Here’s an example:

Abigail has a pension pot worth £400,000 when she reaches 55. She decides to draw down £100,000 from her pension and continues to contribute £4,000 per year.

At 65 she retires but leaves her pension invested as her husband has a generous workplace pension. She continues to contribute £3,600 per year (the maximum for a non-earner).

At 75 years old her pot is worth an impressive £1,035,388 (assuming 5.5% investment growth). She will owe a £15,572 lifetime allowance charge (25% on the amount over the lifetime allowance - £1,035,388 + £100,000 minus £1,073,100) plus income tax when she comes to draw her pension. Of course, the calculations will be different if the lifetime allowance limits change.

How does SIPP lifetime allowance work for defined benefit schemes?

If you’ve got a defined benefit pension, then the lifetime allowance rules still apply.

Your pension pot is valued at 20 times your annual pension plus any lump sum. This is added to any defined contributions pensions to work out your total pension pot.

What happens if I go over my SIPP lifetime allowance?

If your pension breaches the lifetime allowance, then you won’t usually owe anything straight away.

You’ll have to pay a lifetime allowance charge when you withdraw your pension or reach 75 years old. If you die with some pension remaining, then this may also a trigger a tax charge.

When you withdraw a lump sum, you’ll be charged 55% tax on any excess, over the lifetime allowance.

And when you take a flexible income through drawdown, you’ll be charged 25% on the excess amount and then your normal rate of tax on the remainder. This adds up to 55% tax in total if you’re a higher rate taxpayer.

Will the SIPP lifetime allowance change in the future?

The lifetime allowance is currently frozen at £1.073 million until 2026. However, it has varied between £1 million to £1.5 million since it was introduced in 2006–2007, sometimes moving down as well as up.

It’s anyone’s guess what the government will decide to do in the future. The rules may change completely, or the lifetime allowance may remain frozen for some time to come.

Is it worth exceeding the lifetime allowance?

There are some rare circumstances where it may be worth breaching the lifetime allowance. You may decide that tax relief, employer contributions or avoiding inheritance tax make it worthwhile to exceed the allowance.

It’s a complex calculation and it’s a good idea to speak to an independent financial adviser or a solicitor for advice based on your situation.

How do I protect my lifetime allowance?

It’s sometimes possible to protect or increase your lifetime allowance as the lifetime allowance has reduced from £1.25 million in 2016.

If your pension was worth £1 million on 5 April 2016, you have two options. You can apply to increase your personal lifetime allowance to the value of your pension on 5 April 2016 or £1.25 million, whichever is lowest. You can keep paying in but will owe tax on pension withdrawals over your protected lifetime allowance.

Alternatively, you can apply for fixed protection which fixes your lifetime allowance at £1.25 million, but means you’re no longer allowed to pay into your pension.

If you’re thinking about applying to protect your lifetime allowance, then speak to an independent financial adviser to make sure you choose the most suitable option for your circumstances.

How do I avoid reaching the lifetime allowance?

Even if you’re not currently close to breaching your lifetime allowance, it’s possible you will reach it in the future, especially if you keep your pension invested throughout your retirement. But, fortunately, there are a few things you can do to protect your wealth.

Many investors choose to prioritise ISA investing or contribute to a spouse’s pension if they’re getting close to their lifetime allowance. You can currently contribute £20,000 per person into an ISA and it’s possible to get tax relief on payment of up to £3,600 into a non-earning spouse’s pension.

Other investors consider taking a partial annuity before they breach the lifetime allowance or retiring earlier than planned.

The lifetime allowance may also affect your decision on when to take a tax-free lump sum. Taking a lump sum early, even if you reinvest it in an ISA, means that your fund will be worth less in years to come.

If you think you might breach the lifetime allowance in the future, then it’s important to get advice from a financial adviser. They will look at all the facts and advise you on the best course of action for you.

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Important information – SIPPs are aimed at people happy to make their own investment decisions. Investment value can go up or down and you could get back less than you invest. You can normally only access the money from age 55 (57 from 2028). We recommend seeking advice from a suitably qualified financial adviser before making any decisions. Pension and tax rules depend on your circumstances and may change in future.