What is the Pensions Lifetime Allowance? What are the rules?
What is the Pensions Lifetime Allowance? What are the rules?
The Pension Lifetime Allowance (LTA) is the amount you can save into your pension pot and retain the full tax benefits. Exceed this amount and you may pay additional taxes.
A background to tax on pensions.
In most cases, the tax rules around the Pension Lifetime Allowance won't apply as the allowances are generous enough to exclude the majority of pension savers. However, many higher-earning senior executives, company directors, shareholders and business owners will opt to pay a higher portion of their salary into their pension pot for retirement (pension contribution), rather than take it as income to reduce their income tax liability.
Typically, the payments made into a private pension will not incur a tax charge, up to a certain threshold. This includes workplace pensions, personal pensions, stakeholder pensions and the less common 'overseas pension schemes' that qualify for tax relief in the UK. To qualify for tax relief, your pension scheme must be registered with HMRC.
Note that in many instances, the money taken out of a pension will be subject to taxation.
How much can I pay into a pension tax-free?
You will have to pay tax on the payments you make into your pensions if:
The amount you pay in exceeds 100% of your annual earnings in any tax year (this affects your tax relief).
The amount you pay in exceeds £40,000 in any tax year (this is your annual allowance).
Your pension savings exceed £1,073,100 over the course of your lifetime (the lifetime allowance).
In more complicated situations, you may also have to pay tax on your pension contributions if the scheme is not registered with HMRC for tax relief or if the scheme's investments are not in accordance with HMRC's rules.
What is the Pension Lifetime Allowance?
As mentioned earlier, those that are saving a significant sum into their pensions each year and those that have selected particularly strong investments may find that the value of their pension savings exceed £1,073,100 at some point in their lifetime. Indeed, in our article discussing how much you need in your pensions to retire, we conclude that those that have been used to living on a large salary will need pension savings exceeding £1.25m as a minimum. For those on this path, the Pension Lifetime Allowance will apply and you may need to pay additional tax.
How to calculate how much of my Pension Lifetime Allowance I have used?
In the simplest terms, all you need to do is add up how much of your allowance you have used in each of your pensions. The question is though, what counts towards your allowance? Note that your state pension benefit is excluded from your Pension Lifetime Allowance.
Defined Contribution Pensions.
Calculating how much of your Lifetime Allowance you have used for defined contribution pensions is quite straightforward and is simply the capital value of each of your pension pots added together. A defined contribution pension scheme is the most common type of pension scheme used by private companies and they typically involve you and your employer paying a regular amount in each month. A defined contribution pension scheme can be a workplace pension or a personal pension.
For example, you may have a capital value of £148,000 in one UK pension, a capital value of £568,000 in another and a capital value of £32,000 in one more. Added together, you will have used £748,000 of your £1,073,100 Lifetime Allowance.
Defined Benefit Pensions.
Defined benefit pension schemes are less common today, but still exist in larger companies and in the public sector (such as the NHS pension scheme), and you will typically receive a pension that is based on how long you have worked for a company and what your final salary is.
Calculating the amount of your Pension Lifetime Allowance you have used in a defined benefit pension scheme is slightly more difficult than in a defined contribution scheme. Typically, you have to multiply the first tax year pension benefit income by 20 and then add any lump sum payments made. As an example, if your annual pension income in the first year is £74,500 and you will receive a lump sum of £125,000 you are sure to be well above the Lifetime Allowance threshold of £1,073,100 and there is likely to be a tax liability (£74,500 multiplied by 20 is £1,490,000, plus £125,000 is £1,615,000.
In either case, your pension providers may from time to time request information about your other pensions to check if you are near to or have exceeded your Lifetime Allowance. This most frequently happens at the point you want to start taking money from a pension pot when you turn 75 and if you are going to transfer your pension overseas.
Other events that affect the Lifetime Allowance
It’s important to note that the timing of when you started taking or start to take your pension benefits will also affect how they are calculated for Lifetime Allowance purposes. For example, if you started receiving a pension before 6 April 2006 and then subsequently started one after this date, this is valued differently to the standard calculations outlined above.
Some lump sum death payments made by pension schemes or employer death in service arrangements may also count towards the Lifetime Allowance. And to add further complication, the Lifetime Allowance will be tested at age 75 and on death in certain scenarios.
How much tax will I pay if I exceed the Pension Lifetime Allowance?
As mentioned above, it's usually only when you are looking to take money out of a pension, turn 75 or want to move it overseas that your pension providers will calculate the amount of tax you owe (known as the 'Lifetime Allowance Tax Charge', 'LTA Charge', Lifetime Allowance Charge' or 'LTA tax charge'). The tax paid is only on the amount above the Lifetime Allowance threshold and is more if you take it as a lump sum than if you take it as cash withdrawals or as a regular pension payment.
At the time of writing you will pay:
55% tax if it is taken as a lump sum.
25% tax if you take the money in any other way.
Typically your pension provider will deduct the tax charge and pay it to HMRC directly before you start taking your pension and it's essential to report that the tax has been paid via a self-assessment tax return.
Note that if you die before you take the pension, HMRC will send the tax charge bill to whoever inherits your pension fund.
How can I protect my Pension Lifetime Allowance?
The Pension Lifetime Allowance was drastically reduced in 2016 from £1.25m to £1m (the most it has been since 2006/7 was £1.8m in 2010/11 and 2011/12). As a result, you may be eligible for ‘individual protection’ or ‘fixed protection’ of your pension saving and of your Pension Lifetime Allowance at previous thresholds by applying to HMRC directly - this is known as 'Lifetime Allowance Protection' or 'LTA Protection'. Obtaining financial advice in these circumstances can save thousands of pounds in unnecessary tax.
Conclusion
As you can see, those that are building sizable pension savings may wish to carefully consider how much they pay into their pensions once they have utilised their Pension Lifetime Allowance. It may be the case that taking earnings as income or dividends today and building up ISA savings for tax-free income in retirement may be more tax efficient in the long term, for example. It's important to remember though that individual circumstances will vary which is why it is crucial to seek financial advice from a pension expert who is authorised and regulated by the Financial Conduct Authority along the way, whatever your pension arrangement is.
What’s next?
If you need help or advice on your personal or business finances or if you want to consider investing to make your money work harder, you can get in touch with one of our advisors for independent financial advice. We offer a free initial consultation and although we are based in Tunbridge Wells, we advise clients across the UK.
Don’t forget, this article offers general financial information and should not be taken as personal advice. Remember that investments and pensions can go up and down in value, so you could get back less than you put in. Tax rules can change and the benefits depend on individual circumstances.