In the budget earlier this year, the Chancellor announced that the pension lifetime allowance would be frozen until April 2026 at the current level of £1,073,100. The government forecasts that this action will raise a billion pounds in public finances over the next five tax years.
The lifetime allowance
The lifetime allowance is a limit on the amount any individual can hold across all their pensions whilst still enjoying the full tax benefits. All monies accrued in pensions including workplace pensions, SIPPs and final salary schemes are included in your personal lifetime allowance. The only exception is your state pension together with some smaller pension amounts that can be taken outside of the lifetime allowance rules.
Whilst it is possible to have pensions above the lifetime allowance, if we try to access these benefits as income then we first must pay a penalty tax charge to HMRC of 25pc on the excess (the LTA charge is 25pc if the excess is taken as an income, or 55pc if the excess is taken as a cash lump sum). Once the charge has been settled, the amount you choose to draw from the excess is taxed at your marginal rate of income tax.
Before the freeze was announced, the lifetime allowance was expected to continue to rise each year with Consumer Price Index inflation as happened between 2018 and 2020. This would have helped many pensioners retain more tax-free lump sum and pay less in lifetime allowance charges. The freeze at the current level means that the pension lifetime allowance will now affect more people than anticipated; people who would otherwise have avoided it.
So, what impact could the government’s action have on pensions and pension holders in the coming years and what are the actions available to them?
What actions can we take?
The first step is knowing what your pensions are currently worth and checking your current exposure to the lifetime allowance limit. We use cash flow modelling software to forecast what an individual’s lifetime allowance impact might be in the future which gives a reliable indication of what action may be needed and when. Once we have established the current and potential future position, there are a number of actions we can take, which could potentially include:
Apply for a higher level of lifetime allowance: Those with pensions above £1 million (as at 5th April 2016), or alternatively have ceased pension contributions from April 2016 onwards may be able to apply to HMRC for a higher level of lifetime allowance.
Review continued contributions to pensions or consider other savings options: Given the many pension tax benefits, it can sometimes still make financial sense to continue contributing to a pension even when already over the lifetime allowance. Whether this is the correct course of action will be based on an individual’s personal tax position and it is important to seek individual advice.
There are however benefits to saving into multiple types of tax vehicles (e.g. ISAs) alongside pensions. In doing so, this gives you more options and flexibility when structuring a tax efficient strategy to meet expenditure needs in retirement.
Plan the order and timing of any pension drawings: Importantly, the lifetime allowance charge is paid when we choose to take benefits in excess of the cap. This does allow for some planning to take place in terms of the timing and order that we choose to draw on pensions.
This is particularly important when we have different types of pension schemes, for instance we might not want to pay the charges from a valuable final salary pension if there are alternative options.
At age 75 (or on death before age 75), the lifetime allowance position is checked, and a final bill will need to be settled with HMRC.
Consider the option of drawing the tax-free lump sum and income from the pensions to minimise the future impact of the charge: There are pros and cons to drawing funds early and given everyone’s financial position and objectives will be different there is no fixed rule here. However, in some cases drawing early may be the right action to take.
A review of the investment strategy considering a potential lifetime allowance charge in the future: A higher charge does mean a higher resulting pension; therefore it would usually be counterintuitive to decrease investment risk for the sole purpose of decreasing a future lifetime allowance tax bill. However, it would be a good time to review if the strategy in place remains suitable.
Getting to a position of being a pension millionaire takes hard work through a commitment to save regularly over the long-term. Hitting this milestone should be celebrated and therefore having to pay a lifetime allowance charge is not necessarily a bad outcome. However, there are ways to manage the lifetime allowance position and it is important that pension owners consider their options with an adviser as part of their overall financial plan. Please get in touch if you’d like some help.
