Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
How does taking a defined benefit pension before 2006 impact your lifetime allowance?
If you took a defined benefit pension pre-A-Day, how do you calculate the proportion of your lifetime allowance it takes up?
Tom Selby, AJ Bell Senior Analyst says:
The lifetime allowance, which caps the amount you can save in a UK pension over your lifetime, was first introduced at ‘A-Day’ in April 2006 as part of reforms designed to simplify the retirement tax rules in the UK.
The lifetime allowance was originally set at £1.5m before being progressively reduced by successive Governments, reaching a low of £1m in 2016/17. Since 2018/19 the lifetime allowance has increased in line with consumer prices index (CPI) inflation, meaning for 2020/21 it stands at £1,073,100.
For those who had already started receiving a defined benefit (DB) pension before April 2006, the Government needed to come up with a formula to determine by how much a person’s lifetime allowance should be reduced. This reduction in lifetime allowance would happen at their next ‘benefit crystallisation event’ (BCE).
A benefit crystallisation event is a point in time at which HMRC tests how much lifetime allowance someone has used.
These include taking your 25% tax-free cash, moving your fund into drawdown, buying an annuity or reaching age 75.
The formula HMRC opted for was simply to multiply the annual income the person receives at the point at which the first post-A-Day benefit crystallisation event occurs by 25. This would then reduce the available lifetime allowance by that amount.
Take someone who started receiving a defined benefit pension in 2005. The pension rises each year in line with retail prices index (RPI) inflation.
On 1 May 2020 they crystallised a £100,000 SIPP, taking £25,000 tax-free cash and keeping the remaining £75,000 invested via drawdown. Because this was their first benefit crystallisation event since A-Day their lifetime allowance will also be reduced by the value of their existing DB pension.
At this point in time the DB pension is worth £20,000 a year, meaning for the purposes of lowering their available lifetime allowance it is valued at £500,000. It will therefore reduce their available lifetime allowance by 46.59% (£500,000 is 46.59% of £1,073,100).
In addition, crystallising the £100,000 SIPP money will further reduce their available lifetime allowance by 9.31% (£100,000 in 9.31% of £1,073,100).
Anyone who has applied for lifetime allowance protection may be entitled to a higher lifetime allowance than £1,073,100.
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