16th June 2015
David Smith, financial planning director at Tilney Bestinvest looks at the ways pensions savers can avoid breaching the reduced £1m Lifetime Allowance for pension contributions….
From April 6 2016, the value an individual can accumulate in their pension pots over and above which a 55% tax charge will apply when benefits are taken – known as the Lifetime Allowance (LTA) – will reduce to £1m from the current £1.25m. Although a £1m pension pot may seem an unattainable figure, research from Tilney Bestinvest shows that even without investing a further penny, many savers who are in the middle of their working lives could in fact be on track to breach the LTA without realising it.
Based on the lifetime allowance increasing annually by 2% from April 2018 (the Chancellor has announced that the LTA will be inflation-adjusted from this date, so we have used the Bank of England’s target rate) and an annual investment return net of costs attained of 5% compound, a 30 year old could breach the Lifetime Allowance by the time they are age 65 if they currently have a pension pot of £360,000 (further examples below).
Unless you have previously secured and retained Enhanced Protection there is no guarantee that a lifetime allowance tax charge can be avoided. However, there are some actions that those with defined benefit pensions can take to try to avoid and/or reduce the potential for their pension benefits to exceed the lifetime allowance:
Do nothing – Incur the lifetime allowance tax charge on the excess above the lifetime allowance. However, some members of final salary pension schemes might be reluctant to continue to fund the costs associated with accruing additional benefits, given that they would effectively be paying the full cost for accruing additional pension benefits only to receive 45% of the entitlement.
Opt out of your defined benefit pension arrangement – Under this option the individual would have to opt out of the defined benefit arrangement and cease future benefit accrual.
Retire early – Many defined benefit arrangements will apply early reduction factors to an individual’s pension entitlement if they take retirement benefits ahead of the scheme’s normal retirement age. It is the pension that you actually receive, and not the pension you could have received, that will be tested against the lifetime allowance. Therefore, by incurring the early retirement factor you could potentially reduce the value of your pension benefits below the lifetime allowance.
Take the maximum tax-free cash entitlement – Some defined benefit pension arrangements will pay a tax-free lump sum in addition to the normal pension entitlement. However, many people are not aware that they can actually receive more tax-free cash by commuting part of their pension entitlement, subject to an overall maximum. The commutation factor will differ between pension schemes, but as long as the commutation factor is below 20 you will be able to reduce the overall value of your pension benefits, for lifetime allowance purposes, by taking the maximum tax-free cash lump sum available.
What should those with defined contribution schemes do?
If we assume that someone has a pension fund of £1.25m (the current LTA) and they are aged over 55, then they could release their full tax-free cash entitlement of £312,500 and retain the remaining £937,500 in drawdown, which would use 100% of their lifetime allowance with no tax charge.
The remaining fund of £937,500 remains invested and would only be subject to a further lifetime allowance check if the individual were to die, purchase an annuity or be in drawdown on their 75th birthday, and the amount tested will be the growth in the fund value from going into drawdown. So if the fund value had grown to £1m at the date of death, £62,500 would be subject to the 55% tax charge. However, income withdrawn from the pension is not subject to a lifetime allowance check, so an individual could simply opt to withdraw the growth in the pension fund as an income (albeit subject to Income tax) and as long as the fund value is below £937,500 at the time of the next Benefit Crystallisation Event no lifetime allowance tax charge should be incurred.
If we assume that a modest 3% (net of charges) annual growth rate is attained, a fund value of £937,500 would increase in value by £28,125, and this amount could be withdrawn as income with an income tax rate of 20%, 40% or even 45%, which is better than the 55% tax charge.
Smith adds: “We would like to see the highly punitive Lifetime allowance scrapped, as it penalises decent investment performance and is a deterrent to making retirement provision. However, as the rules currently stand, we would urge those who believe they may breach the lifetime allowance to seek professional financial planning advice, especially given the complexity involved.”
The following pension pots for investors of different ages could breach the Lifetime Allowance:
|Current Pension Assets held which might breach adjusted Lifetime Allowance|
|Current Age||By age 55||By age 60||By age 65|