The limit on how much you can put into a pension and benefit from tax relief is very much worth keeping in mind

HOW TO AVOID FALLING FOUL OF THE LIFETIME ALLOWANCE

Squirreling away over £1 million might feel like a far-flung dream for many retirement savers.

However, recently published HMRC figures show that in 2019/20 pension schemes reported over 8,500 instances where the lifetime allowance had been breached. The total value of the related charges was £342 million – a 21% increase from £283 million in 2018/19.

What’s more, the Government’s decision to freeze the lifetime allowance at just over £1 million (£1,073,100 to be exact) until 2025/26 means that more people are likely to be pulled into its orbit in the coming years.

As a result, understanding how the lifetime allowance works – and when it might make sense to breach it – will become increasingly important.

THE LIFETIME ALLOWANCE IN BRIEF

The lifetime allowance caps the total amount you can save in a pension without having to pay an additional tax charge.

While the current level is just over £1 million, over the years successive governments have whittled the figure down in a bid to raise revenue for the Exchequer (in fact back in 2011/12 the figure was as high as £1.8 million).

Each reduction in the lifetime allowance has resulted in the creation of a new set of ‘protections’, allowing some people to keep a higher personal  lifetime allowance.

You can read more about these protections and the conditions that come with them here. 

Your pension savings will be tested against the lifetime allowance when a ‘benefit crystallisation event’ occurs. These events include taking tax-free cash, buying an annuity, entering drawdown, starting a scheme pension (if you have a defined benefit pension) or taking an ad-hoc lump sum (sometimes referred to as ‘UFPLS’).

A test will also be carried out on your 75th birthday if you have funds that haven’t been used to buy an annuity or provide a scheme pension – including any growth your fund has enjoyed if you have chosen to remain invested in retirement in drawdown.

HOW THE LIFETIME ALLOWANCE CHARGE WORKS

If you breach the lifetime allowance, a charge will be applied to the excess. This charge will be 25% if the money is left in the pension or 55% if taken out of the pension.

Take, for example, someone who breaches the lifetime allowance by £1,000. If the excess is left in the pension, a 25% charge will be applied, reducing the fund to £750. When these funds are later withdrawn, if income tax is paid at 40%, the amount the person will receive after tax will be £450.

If the person instead takes the £1,000 out as a lump sum, they will pay a 55% lifetime allowance charge (and no income tax), meaning they also end up receiving £450.

For this reason, if you expect to pay less than 40% tax on your withdrawals it can make sense to keep your excess in the pension and pay the 25% charge.

Where it might make sense to breach the allowance 

For example, take a higher-rate taxpayer who pays £2,000 into their pension via salary sacrifice, matched by a £2,000 employer contribution.

If this resulted in them exceeding the lifetime allowance by £4,000, it will be subject to a maximum lifetime allowance charge of 55%, meaning they would receive £1,800 if they take the excess as a lump sum.

This might be less than they’d have received if they hadn’t breached the lifetime allowance, but as the £2,000 salary sacrifice only ‘costs’ £1,200 – due to the saver receiving higher-rate tax relief on the money paid in – this still effectively represents a 50% return on their contribution.

BREACHING THE LIFETIME ALLOWANCE

Writing my weekly Shares column, I’m often asked by those close to the lifetime allowance how a lifetime allowance charge can be avoided. However, in certain circumstances it can make sense to take the lifetime allowance charge on the chin.

If you receive matched employer contributions in your workplace pension scheme, for example, these could be worth more than any lifetime allowance charge you might pay.

Those approaching the lifetime allowance could, of course, reduce the risk in their portfolio in order to ensure investment growth doesn’t push them over the allowance – or indeed place their entire fund in cash. However, this could also have a negative impact on your overall retirement outcome.

Take someone who has just hit the lifetime allowance of £1,073,100. If they removed all risk from their investments, they could avoid paying a lifetime allowance charge.

But if they stuck with their investment strategy and the fund grew to £1,200,000 when they came to access it, the maximum charge on the excess they could pay would be £69,795 (55% x £126,900), leaving £57,105 to take as income.

So investment growth has still ultimately benefited the saver (although by less than it would have done before taking the lifetime allowance charge).

OTHER OPTIONS

Given the lifetime allowance charge aims to remove the upfront tax advantage of saving in a pension (although investment growth within the pension is still tax-free), personal contributions that don’t attract an employer match might be better invested elsewhere.

ISAs, for example, benefit from both tax-free investment growth and tax-free withdrawals. If you have already used up your £20,000 annual ISA allowance, you can invest in a general investment account (GIA) and use your annual dividend allowance of £2,000.

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