Following on my blog How much can I pay into a pension?, this blog looks into, how much you can build up within your pension and answers the questions What is the Lifetime Allowance?
What is the Lifetime allowance?
The Lifetime allowance is simply the amount of money that can be paid out of your pension without incurring a tax charge. The pay-outs could be in the form of income or lump sums from all pensions apart from the state pension. The lifetime allowance is currently £1,055,000 (2019/20). It has been reduced over recent years from £1.5m when it was introduced in 2006 it went up to the high of £1.8m and down as low as £1,000,000. The LTA is now set to increase with inflation (CPI) each year.
How to work out your lifetime allowance
How you work out the lifetime allowance depends not the type of pension you are in; Defined Contribution or Defined Benefit.
For defined contribution pensions the value of the pension fund used to pay income or a lump sum will be tested against the lifetime allowance. For example, if you use £100,000 to pay 25% tax free cash and the balance was used to generate and income, the £100,000 would use 9.47% of your lifetime allowance. Your provider will be able to confirm the percent of the lifetime allowance you have used.
For defined benefit pensions, the value of the plan is calculated by taking the income and multiplying it by 20. Where the scheme offers a lump sum without having to give up some of your pension, you would multiply the income by 20 and add the lump sum amount. For example, if your pension was expected to pay £15,000, the amount of lifetime allowance this would use is £300,000 or 28.44% of your lifetime allowance. If the scheme paid a lump sum of £50,000 in addition to the income, this would use £350,000 (33.18%) of the lifetime allowance.
Some lump sum death benefits may also be tested against the lifetime allowance on death before age 75. In addition to this, any unused benefits will be tested against the lifetime allowance at age 75.
What is the lifetime allowance charge?
If you exceed the lifetime allowance, you will incur a tax charge. How much you pay will depend upon whether you take the excess as income or a lump sum.
If you take the excess as a lump sum, this will be taxed at 55%. Your pension provider will usually take the tax charge and pay the balance to you.
The amount of excess taken out as income will incur a charge of 25%. You may think that it is a no brainier to take the excess as income rather than a lump sum. However, if you were taking the excess as £5,000 per annum, your provider would deduct the 25% tax charge. Thus you would receive £3,750. If you are a higher rate tax payer, you would have 40% tax deducted from this amount. You would therefore receive £2,250 which is the same as 45% of £5,000 (i.e. 55% tax having been deducted).
Protecting against the lifetime allowance charge
If you wish to avoid paying the tax charge, you may need to keep an eye on the value of your pensions to make sure you do not exceed the lifetime allowance.
In some instances, you may also be able to apply for protection. Various types of protection have been introduced each time the lifetime allowance has been reduced. For example, when it was reduced from £1.25m to £1m on 6th April 2016, two types of protection were introduced:
Where your fund value exceeded £1m this could be protected to a maximum of £1.25m and additional payments could be made into the plan
Where you have not made payments into your plan since 5th April 2016, you could apply for fixed protection 2016 to preserve the lifetime allowance of £1.25m
To find out more regarding protecting your lifetime allowance, either speak to a Financial Adviser or visit https://www.gov.uk/guidance/pension-schemes-protect-your-lifetime-allowance
This blog has answered the question What is the lifetime allowance? We have also looked at how to work out the lifetime allowance you have used, the lifetime allowance charge and protecting your lifetime allowance.
If you would like to discuss your pensions or your lifetime allowance, contact me for a complimentary, no obligation initial meeting.