Investors attempting to pick their way through the mire of pension tax rules could be forgiven for losing the will to live.

However, if you’ve saved diligently and have a retirement pot approaching £1 million, it’s vital you know how the system works so you can shelter as much of your hard-earned pension as possible from the taxman.

What is the lifetime allowance?

The lifetime allowance dictates how much you can withdraw from your pension in a tax-incentivised environment. Currently, the lifetime allowance is set at £1m – although as I’ll explain later there are ‘protections’ which may allow you to lock in to a higher allowance.

If you breach your lifetime allowance, the charge you pay depends on how you withdraw the excess above £1m. If you take it as a lump sum before age 75, a 55% charge will be applied to the excess. If you leave it in the scheme to take it as an income later, an immediate 25% charge will be levied.

If you choose the latter option, don’t forget that when you take money out of the scheme later you’ll also pay tax at your marginal rate of income tax meaning the two options are likely to lead to broadly the same tax being paid.

How does it work?

It’s important to note that a pension which becomes worth more than £1m won’t instantly be subject to a lifetime allowance charge. It is only when a benefit crystallisation event (horrible jargon, sorry) occurs that your pension scheme ‘tests’ whether or not you need to pay a charge.

Benefit crystallisation events include buying an annuity (a guaranteed income for life), taking a tax-free lump sum or keeping your money invested and choosing drawdown.

For example, if someone buys an annuity worth £300,000, they have used up 30% of their £1m lifetime allowance.

What if I have a defined benefit pension?

The lifetime allowance still applies if you have a defined benefit or ‘final salary’ pension, although this involves a different calculation.

When the pension is put into payment, you multiply your annual entitlement by 20 and add that figure to any tax-free cash you get in order to calculate what you’ve used up.

Can I have a higher lifetime allowance?

You may already be lucky enough to have one of the various protections that have been available from HMRC since 2006.

If not, it is possible to lock in a higher lifetime allowance of up to £1.25m by applying for one or both of the forms of protection introduced in 2016 – ‘fixed’ protection and ‘individual’ protection.

If your total pension savings are worth more than £1m, or you think they might grow to more than £1m, you should consider checking if you’re eligible to apply.

How do they work?

Fixed protection allows you to keep a £1.25m allowance provided you have no other protections, other than the 2014 version of individual protection.

You don’t need to have pensions already worth more than £1m but the catch is you can’t make any more contributions into your pension – if you do, you lose the protection.

The 2016 version of individual protection is available to you if the value of your pensions at 5 April 2016 was more than £1m. Your allowance is protected at that respective amount. You can continue contributing to your pension without worrying about losing this protection.

Consider taking financial advice

As you’ve probably worked out now, the lifetime allowance regime is hideously complicated.

Unfortunately I can’t cover all the vagaries in this article, but if you think you might be affected it could be worth speaking to a financial adviser to help you navigate the quagmire.

TOM SELBY, Senior analyst, AJ Bell

Case study: John’s pension is valued at more than the current lifetime allowance

At 5 April 2016 John had £550,000 in his SIPP and £650,000 in his employer’s pension scheme, £1.2m in total. He decided to apply for fixed and individual protection 2016.

In 2020, when John is 60, he decides to go into drawdown, take all of his tax free cash and leave the rest in his fund. At this point the lifetime allowance is £1,050,625 (assuming CPI inflation increases of 2.5%).

Scenario 1: John’s fund has grown and is now valued at £1.3m. John uses his fixed protection of £1.25m and has an excess of £50,000.

He decides to leave this in the fund and pays an excess charge of 25% or £12,500.

If John had not had the protection then the excess would have been £300,000 and the tax charge £75,000.

Scenario 2: John’s fund has fallen to a value of £1m which is below the £1.2m allowance for his individual protection.

John decides to maximise his pension contributions and pays in £160,000 gross using his £40,000 annual allowance and each of the previous three years’ unused annual allowances – previously he could not make contributions and keep his fixed protection. His fixed protection is now revoked.

John now uses his individual protection of £1.2m to access his full fund of £1.16m with no excess tax charge.

If John had not had individual protection he would only have been able to contribute £50,625 to bring his fund value up to the standard lifetime allowance.

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