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.
Find out how much you can save in your pension over your lifetime
The Government gives incentives to people who save in pensions, but there is a limit to its generosity and if you save too much then you may be hit with tax charges.
How much can someone save in pensions over their lifetime?
There isn’t a hard limit on the amount you can save over your lifetime, but the lifetime allowance caps the amount you can save without facing tax penalties.
The lifetime allowance covers all your savings in UK registered pension schemes. This includes defined contribution pensions (such as SIPPs) and any defined benefit pensions (such as final salary schemes) you may have.
This overall allowance has changed over the years but is currently set at £1,073,100 and will remain at that level up to and including the 2025/26 tax year. If you save more than the lifetime allowance, tax charges will apply to any excess.
When does someone use their lifetime allowance?
Your pension savings are tested against the lifetime allowance at certain trigger points – these are known as benefit crystallisation events or BCEs.
For most people the first trigger point will be when you take your tax-free cash – officially known as a pension commencement lump sum or PCLS.
It isn’t possible to take PCLS without doing something with the rest of your pension. Depending on the type of pension scheme you will either start taking a scheme pension, buy an annuity or allocate funds to take as income drawdown, either immediately or at some point in the future.
All of these are also BCEs. It’s important to remember that allocating funds to use for drawdown is the event that triggers the test, not when you actually take income, which could be many years later.
You can also choose to take funds out of your pension as a lump sum(s) which is part taxed, part tax-free – known as an uncrystallised funds pension lump sum or UFPLS. This will also trigger a test.
If you were to die before age 75 without accessing your pension, then your pension savings would be tested on your death. Similarly if you were to transfer your pension out to an overseas pension scheme, then your savings would be tested at that point.
The other time your savings are tested is if you reach your 75th birthday with pension savings that haven’t been accessed. Also, importantly, any funds from which you have previously designated to take income drawdown are tested again.
When it comes to drawdown funds you get a credit for the amount you originally put into drawdown, so the test is on how much your funds have grown since that point. If you’ve being taking income out, meaning the fund value hasn’t grown, you won’t have anything to test.
How does the lifetime allowance test work?
When your pensions savings are tested you use up a percentage of your lifetime allowance. This is calculated as:
John had £1,000,000 in his pension at age 65 and decided to take all his tax-free cash. He didn’t want to take any income.
The amounts tested are:
£250,000 tax-free cash (immediately taken out)
£750,000 designated to drawdown (funds remain in his pension – he can take income from them whenever he likes without triggering another test)
Test 1 (tax-free cash)
£250,000/£1,073,100 x 100 = 23.29%
Test 2 (drawdown fund)
£750,000/£1,073,100 x 100 = 69.89%
Lifetime allowance used
23.29% + 69.89% = 93.18%
On John’s 75th birthday his drawdown fund had grown to £800,000.
£800,000 less the amount previously designated to drawdown (£750,000) is tested against his available lifetime allowance.
Test 3 (age 75 drawdown)
£50,000/£1,073,100* x 100 = 4.65%
*the lifetime allowance applicable at John’s 75th birthday would be used.
Total lifetime allowance used
23.29% + 69.89% + 4.65% = 97.83%
Your pension scheme administrator will carry out the calculations for you and tell you how much of your lifetime allowance you have used.
How does the lifetime allowance work for defined benefit pensions?
If you take tax-free cash from a defined benefit pension this is tested against the lifetime allowance in the same way as described above.
However, with defined benefit pensions you don’t have a fund value, or a set amount that is used to provide you with your income. Instead, you receive a guaranteed income for life.
When you start taking your scheme pension the annual amount you receive is multiplied by 20, and this is the amount tested against your lifetime allowance.
Nadia, 65, starts taking her benefits from her final salary pension. She receives £100,000 tax-free lump sum plus pension income of £15,000 a year.
Test 1 (tax-free cash)
£100,000/£1,073,100 x 100 = 9.31%
Test 2 (scheme pension)
(£15,000 x 20)/£1,073,100 x 100 = 27.95%
Lifetime allowance used
9.31% + 27.95% = 37.26%
Once a scheme pension is in payment it is only tested against the lifetime allowance again if it is increased by a certain amount. This is a relatively unusual occurrence and outside the scope of this article. There is no test at age 75 for scheme pensions that are in payment.
Is it possible to have a lifetime allowance above £1,073,100?
When the lifetime allowance was introduced in April 2006 it was set at £1,500,000. It increased for a number of years before peaking at £1,800,000 in 2010/11. Since then it has been cut on three separate occasions.
When the lifetime allowance was first introduced, and on each occasion when it has been cut, protection has been available for those who already had savings above the new level (primary or individual protection) and for those who stopped saving into their pension (enhanced or fixed protection).
If you hold enhanced protection then no lifetime charge will ever arise. For other types of protection you will have a protected value above £1,073,100 that will be used when calculating your lifetime allowance usage.
What happens if you breach the lifetime allowance? Does it ever make sense to do this?
If you breach the lifetime allowance the excess funds will be subject to the lifetime allowance charge, also known as LTAC.
If you choose to take the excess funds out of your pension, then a 55% tax charge will be deducted by the scheme administrator and the balance paid out to you.
Alternatively, you can leave the excess funds in your pension and the scheme administrator will deduct a 25% tax charge.
When you later come to withdraw these funds, they will be subject to income tax. If you are a higher rate taxpayer then this means you effectively pay the same rate of tax as if you take it as a lump sum - i.e. 55%.
£10,000 excess, higher rate taxpayer.
Taken as a lump sum taxed @55%
= £5,500 LTAC paid to HMRC
= £4,500 paid to you
Excess left in pension taxed @25%
= £2,500 LTAC paid to HMRC
£7,500 later paid subject to income tax @40%
= £3,000 income tax paid to HMRC
= £4,500 paid to you
Although nobody likes paying tax, there are instances where it makes sense to pay a lifetime allowance charge, rather than taking action to avoid it.
For example, if your employer is making contributions to your pension which ultimately may take you over the lifetime allowance, it is still better to have 45% of something rather than 100% of nothing, if there isn’t an alternative to the pension contributions.
Some may consider taking income that they don’t otherwise need to reduce the growth in the drawdown fund that is tested at age 75.
It is important to remember that your pension is usually outside your estate on your death, whereas if you withdraw funds and don’t spend them in your lifetime, they are liable to inheritance tax.
While funds remain in the pension, they have the advantage of compound tax-free growth, so will grow at a faster rate than outside a tax wrapper.