The budget on March 3rd brought with it the announcement that the Pensions Lifetime Allowance (LTA) will remain at the current level of £1,073,100 until April 2026. It had been expected to increase each year in line with inflation (as measured by the Consumer Price Index), as it has done each year from 2018/19. There is also of course no guarantee that government will resume inflation indexation from April 2026.
The lifetime allowance was due to increase by only 0.5% this tax year due to the low inflation figure in September, so the freeze will have a small impact this year. However, it will remain frozen for another 5 years. As inflation should also start to pick to more normalised levels, an increasing number of individuals should start to be affected by the freezing of the LTA.
In this article we will address the following questions:
- What is the Pensions Lifetime Allowance?
- How is it calculated?
- What are the tax charges for breaching it?
- Could you be affected?
- What are some strategies to mitigate the charge?
What is the Lifetime Allowance?
The Pensions Lifetime Allowance (LTA) is the overall limit of tax privileged pension funds a member can accrue during their lifetime, before a Lifetime Allowance tax charge applies. The standard LTA is currently £1,073,100 (2020-2021) and as mentioned, will be frozen at this level until April 2026.
How is it calculated?
The calculations are rather complex and we will need to simplify somewhat for the purpose of this article. We need to look at 2 types of pensions separately: Defined Benefit and Defined Contribution (personal pensions, SIPPs etc) pensions.
For Defined Benefit (also called Final Salary) pensions, when benefits are first taken, the annual pension amount is multiplied by 20 to get your calculation for PLA purposes. Any Pension Commencement Lump Sum (also called ‘tax-free cash’) is also added to the calculation.
For Defined Contribution pensions, when benefits are taken (or crystallised in pension speak) the sum in question is tested against the annual allowance. If any part of the pension benefit is not ‘crystalised’ by the age of 75, it is then subjected to one final test.
At retirement, say at 60, you:
- begin to receive a £40,000/year final salary pension
- receive a £110,000 tax-free lump sum from the same pension at commencement and;
- from your defined contributions pension (say a SIPP), of £400,000 decide to take a 25% tax-free pension commencement lump and put the remaining £300,000 into drawdown.
Your calculations towards the Lifetime Allowance would be:
£40,000 x 20 = £800,000 (final salary pension)
Add £110,000 (tax-free cash from final salary scheme)
Add £300,000 (SIPP put into drawdown)
Add £100,000 (tax-free cash from SIPP)
You would have breached the lifetime allowance by £236,900 (£1,310,000 minus the allowance of £1,073,100.
What are the tax charges?
There is no tax-free cash available on any funds above the lifetime allowance. If any funds above the Lifetime Allowance are taken as a lump sum, they are taxed at 55%. If they are taken as income, then they are taxed an additional 25% of tax (in addition to any income tax you may owe on your pension).
Could you be affected?
It is important to note that now that it has been frozen, the LTA tax charge will affect more people. This is a tax on future savings and pension growth and not necessarily just on those that are near the allowance limit already. The table below shows a few examples:
As can be seen, the longer the time until retirement or the higher the returns enjoyed along the way, the lower our pension value needs to be today before the LTA tax charge becomes an issue. Through the power of compounding, we can be quite some way from the allowance and still have it become an issue in the future. Of course this will be exacerbated if further regular contributions are made along the way.
What are some strategies to mitigate the charge?
This is where taking advice can really make a difference. An initial assessment in regards to the LTA should look at:
- The current value of both Defined Benefit (DB) and Defined Contribution (DC) pensions in regards to the LTA
- The time to retirement vs the nature of the investments – is it probable that the LTA at some point might be reached?
If the LTA is likely to be reached or your pensions are already valued over the £1,073,100 then options to consider may include:
- Stopping your pension contributions
- Asking your employer to stop their pension contributions (will the employer compensate you in some other way?)
- Looking at how taking the pension commencement lump sum (tax-free cash) affects your LTA
- Looking at how the timing of taking your DC or DB pension affects your LTA.
- Looking at how increasing your pension income vs other sources of income affects your LTA tax charge (keeping in mind you overall tax burden).
- Whether letting your funds accumulate past the LTA could form a part of your Inheritance Tax strategy.
- Ensuring you’re aware that tax-free cash is only available on funds below the LTA. All funds over the LTA are taxed.
The pension Lifetime Allowance is a complex area of financial planning. I hope this article helped to outline some of the issues. Please get in touch on 0207 097 4968 or firstname.lastname@example.org to discuss your pension and financial planning needs.
Pensions are long-term investments, the value of your investment and the income from it may go down as well as up.
Your eventual income may depend upon the size of the fund at retirement, future interest rates and tax legislation.
Past performance is not a reliable indicator of future performance.
This guide is for information purposes and does not constitute financial advice, which should be based on your individual circumstances.
Levels and bases of, and reliefs from taxation are subject to change and their value depends on the individual circumstances of the investor.