How to get the most out of your retirement savings by understanding the tax rules
Thursday 09 Jan 2020 Author: Tom Selby

The pensions lifetime allowance is becoming a concern for an increasing number of the UK population. Between 2010/11 and 2017/18 – the most recent data available – the number of times savers were hit with charges for exceeding the lifetime allowance increased four-fold.

The total value of these charges, compiled by HMRC via accounting for tax returns, has risen from £37m at the start of the decade to £185m in 2017/18. The overall figure is likely to be higher as HMRC’s published data doesn’t include figures for those who pay the charge a different way, for example through self-assessment tax returns.

Government cuts to the lifetime allowance over the last 10 years have been partly responsible for this trend. Back in 2010/11, the lifetime allowance stood at £1.8m. Roll forward to 2019/20 and that figure has been slashed to £1,055,000 – although it at least now rises annually in line with Consumer Prices Index (CPI) measure
of inflation.

While a pension of just over £1m is clearly significant, a rising number of people – particularly those who started saving early, enjoy strong investment growth and/or have generous defined benefit (DB) entitlements – are at risk of breaching the limit.

Understanding how the lifetime allowance works – and the various rules in place to help protect the value of your pot – is therefore more crucial than ever. This article will go through all the main points so you can get the most out of your retirement savings and understand the tax rules.

What is the lifetime allowance?

• The lifetime allowance is the limit the Government has set for the value of funds that you can have across all your pension pots in total.

• The current lifetime allowance is £1,055,000 and this figure will increase each tax year in line with consumer price inflation (CPI).

• If you exceed the lifetime allowance, you can take the excess as a lump sum less tax of 55% or you can keep the excess within the pension fund and pay a tax charge of 25%. If you keep the excess in the fund you will pay income tax on it as normal when you withdraw it. If you have obtained some form of protection you will be able to protect more of your fund from these charges.

Valuing your pensions for the lifetime allowance

To begin, you need to figure out what your pension or pensions are worth. If you have a defined contribution (DC) pension, such as a workplace pension or a SIPP, valuing your pension for lifetime allowance purposes is straightforward – it’s simply the amount held within your fund.

However, you should note that the amount of lifetime allowance you use will only be calculated when a ‘benefit crystallisation event’ occurs. We will cover these off in the next section.

If you have a defined benefit (DB) pension which provides a guaranteed income for life, HMRC multiplies your guaranteed income entitlement by 20 to calculate how much lifetime allowance you have used up.

Any tax-free cash that is paid separate to the pension also has to be added in. Again this is only tested when a benefit crystallisation event occurs, but you can work out your potential lifetime allowance usage from the figures on your annual pension statements.

If you have both DB and DC pensions then you will need to add these together to determine whether you’re at risk of hitting your lifetime limit.

Turning your pension into a retirement income

HMRC will test how much lifetime allowance you have used when a benefit crystallisation event occurs. There are a number of such events you should familiarise yourself with.

• If you have a DC pension such as a SIPP, a lifetime allowance test will be applied when you turn your fund into an income.

• If you buy an annuity with a pot worth £100,000, for example, this amount will be
tested against the lifetime allowance. The same applies if you commit the money to drawdown, take tax-free cash or an ad-hoc lump sum.

• Any DB entitlement you have needs to be multiplied by 20 to determine how much lifetime allowance you have used up. Any separate tax-free cash entitlement also needs to be added in.

To help illustrate the latter point, let’s say your DB pension is worth £20,000 a year when you start receiving it. For the purposes of the lifetime allowance, you’d have used up £400,000 in 2019/20. If you don’t have any other pensions and don’t take any tax free cash, you can have a DB pension of just over £50,000 a year in 2019/20 without breaching the lifetime allowance.

An important point to remember is that whenever a lifetime allowance test is applied, you actually use up a percentage of the available allowance in that tax year, rather than a pounds and pence amount.

So in the above DB example you would have used up 37.91% of your lifetime allowance, whereas if in 2019/20 you committed £100,000 to drawdown, this would use up 9.47% of your lifetime allowance (i.e. £100,000/£1,055,000).

This is important because, as the value of the lifetime allowance changes with inflation, you always measure the remaining percentage of your own lifetime allowance against that value
to work out what you have left available in pounds and pence.

Reaching age 75 in drawdown

For those who enter drawdown, there will usually be two benefit crystallisation events: one when you put the money into drawdown, and again when you reach age 75. It’s probably easiest to explain how this works with an example.

Take someone aged 64 with a £1m fund who decides to crystallise everything and enter drawdown, taking 25% as tax-free cash (£250,000) and using the remaining £750,000 to provide a retirement income. This would use 94.78% of their total lifetime allowance in 2019/20 (£1,000,000/£1,055,000).

If they take no more withdrawals but their remaining pot grows to £1.3m by their 75th birthday, the growth in the drawdown fund – £550,000 – would be tested against the lifetime allowance (£1.3m minus the £750,000 that was originally put into drawdown).

Assuming CPI inflation has increased at 2.5% a year, the lifetime allowance could be £1,385,000 by the time our saver reaches age 75. However, because they have already used some of their lifetime allowance, the remaining allowance is worth £72,297 (5.22% of £1,385,000) – this is an example of the point mentioned above about using the remaining percentage of your lifetime allowance when calculating the value of what you have left.

This shows how, even if your fund is worth less than the lifetime allowance at the first test, it could become subject to a charge when you reach age 75.

What level of lifetime allowance charge will you pay?

If you breach the lifetime allowance, the level of charge you pay depends on what happens to the excess.

If you take the excess as a lump sum before age 75 it will be taxed at 55%. If you take the excess as income, or at the age 75 lifetime allowance test, it will be taxed at 25%.

So in the above example the excess at 75 is £477,703 (£550,000 minus £72,297) and the tax charge is £119,426 (25% multiplied by £477,703). The excess less the tax charge remains in the drawdown fund.

Individual protection 2016 and fixed protection 2016

Unfortunately, there aren’t any tricks you can use to dodge the lifetime allowance – the age 75 test in particular ensures those who crystallise a pot just below the lifetime allowance and then enjoy strong investment growth are still at risk of paying a charge.

However, there are various protections that have been introduced since April 2006 which could mean your lifetime allowance is higher than £1,055,000.

There are only two types of protection you can still apply for: ‘individual protection 2016’ and ‘fixed protection 2016’.

Individual protection 2016 was introduced when the lifetime allowance was lowered from £1.25m to £1m in 2016 and was designed to protect those who’d already built up a pension pot worth more than £1m.

• If you had pensions worth over £1m on 5 April 2016 you can apply to HMRC for individual protection 2016, giving you a personal lifetime allowance at that value, up to a maximum of £1.25m. So if you had pensions worth £1.2m on 5 April 2016, that’s your protected lifetime allowance.

If you successfully apply for individual protection 2016 you can continue to make contributions to your pension or pensions, although as those contributions are likely to increase the excess over your protected lifetime allowance, you’ll likely have to pay a tax charge in due course.

One reason you might want to keep paying into a pension when you’re already above the lifetime allowance is if you’re in a workplace scheme offering matched contributions. Even with the tax from a lifetime allowance charge, the 100% bonus of an employer match still represents a great return on your investment.

Fixed protection 2016 allows you to lock into a lifetime allowance of £1.25m. Unlike individual protection 2016, the value of your pensions at 5 April 2016 didn’t need to have been over £1m to qualify.

To keep fixed protection 2016 you are not allowed make any contributions or set up new pensions after 5 April 2016. You must also not have any other forms of protection other than individual protection 2014 (we’ll cover this off in a moment). 

It is possible to apply for both fixed protection 2016 and individual protection 2016 at the same time. This could act as a useful insurance policy if your fund falls in value below £1m, allowing you to revoke fixed protection 2016, retain individual protection 2016 and continue contributing.

Historic protections and how they work

The lifetime allowance has changed several times since April 2006 (sometimes referred to as ‘A Day’), with each change creating a new protection regime.

If you have one of these protections it’s important to understand how the rules governing them work, as a false step could leave you with a tax bill of hundreds of thousands of pounds. Note that you can no longer apply for these protections.

Back in April 2006 the first two types of protection were created: enhanced protection and primary protection.

Enhanced protection (2006): If you have enhanced protection you will not be subject to a lifetime allowance charge when you come to take benefits from your pension no matter what they’re worth. However, you must have stopped being an active member of all pension schemes – both DB and DC – no later than 5 April 2006.

Primary protection (2006): Primary protection was available to individuals who had total pension savings – including any pensions in payment – worth over £1.5m at 5 April 2006. If you have primary protection you will be entitled to your own personal lifetime allowance determined by a ‘lifetime allowance factor’. This should be shown on your lifetime allowance protection certificate (if you don’t have this to hand speak to your adviser or contact HMRC).

To work out your personal lifetime allowance, multiply the higher of the standard lifetime allowance (i.e. £1,055,000 in 2019/20) and £1.8m by your lifetime allowance factor, then add this to £1.8m.

A key difference between primary protection and enhanced protection is that primary protection allows you to continue contributing to a pension or pensions.

Fixed protection 2012 and 2014: There are two other types of fixed protection which you may have, created in 2012 (when the lifetime allowance was reduced from £1.8m to £1.5m) and 2014 (when the lifetime allowance dropped from £1.5m to £1.25m).

These worked in the same way as fixed protection 2016, with the key difference being that they allowed the individual to lock into a higher lifetime allowance (£1.8m for fixed protection 2012; £1.5m for fixed protection 2014).

Individual protection 2014: To complete the protections picture, individual protection 2014 was created alongside fixed protection when the lifetime allowance was lowered from £1.5m to £1.25m.

Individual protection 2014 works in the same way as individual protection 2016, but instead gives you a protected lifetime allowance equal to the value of your pension savings at 5 April 2014.

Beware accidental pension contributions

If you have enhanced protection or any of the three forms of fixed protection then you need to be careful of accidentally building up new pension rights. If you do this, your protection will be lost and you could face big tax charges on any excess.

Perhaps the biggest risk here lies in relation to automatic enrolment, the reform programme that means most people in employment are now enrolled into a workplace pension scheme.

If you have one of these forms of protection you will need to opt-out if you want to avoid losing it. Even if you do opt-out you’ll need to be on your toes, as employers typically re-enrol eligible employees every three years.

Navigating the lifetime allowance is one of the most complicated areas of pensions, with all sorts of pitfalls which risk catching you out.

If you’re at all unsure of how the rules work or simply don’t have time to monitor your pension or pensions, it’s worth considering
paying a financial adviser who can provide personal recommendations based on your individual circumstances, or you could speak with Government-backed guidance service Pension Wise.

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