If your pension pot breaches £1m, you could face punitive taxes when you retire. So how can you protect your funds?
With a significant proportion of the UK population facing a shortfall in retirement income, the government has used tax breaks to encourage long-term pension saving. However, those saving too much could face a potential tax charge of up to 55% if their fund value breaches an upper limit, known as the pensions Lifetime Allowance (LTA).
Under the current rules, which remained largely untouched by today’s Budget, savers are allowed to make an annual pension contribution of 100% of their income, capped at £40,000 per person per year. Those that have followed the advice and made large, regular contributions to their pensions could fall foul of the LTA should they save more than £1m in their pension pot.
How much can I save in a pension before extra tax charges?
The LTA limit has been reduced and frozen several times and there is discussion of limiting this even further. One leaked proposal is to reduce it from just over £1m to around £800,000 in the Autumn Budget on October 27. Any funds above this threshold would be subject to 55% tax if withdrawn as a lump sum, or 25% if paid as income. This will effectively draw many more pension savers into the LTA net.
The LTA cap was first introduced in 2006, when it was set at £1.5m. The threshold was increased in 2010 to £1.8m, before being reduced to £1m in 2016.
It has since risen in line with inflation, with the threshold currently £1.073m. It has been frozen at this level for at least the next five years, a measure announced in the March 2021 Budget.
Why does the LTA matter?
Broadly, there are two types of pension. A Final Salary or Defined Benefit (DB) pension – common in the public sector – pays a proportion of your former salary when you retire.
A Money Purchase or Defined Contribution (DC) pension is found more often in the private sector, and sees contributions from you and your employer invested on your behalf. The value of those investments is the pot of money that you can then use to generate an income through retirement.
A pension fund of £1m may sound like a lot, but if you have a private pension that will only buy you an annual income of just over the annual average salary in the UK.
“Using certain estimates, a £1m pension would roughly generate a £35,000 annual income, which is not an excessive amount for many retirees who find themselves free from work and looking forward to enjoying their retirement,” says Romi Savova, CEO of PensionBee.
One of the anomalies in the rules is that the LTA cap hits those with a private sector pension or personal pension harder than someone who has a public sector pension. Nevertheless, the LTA was blamed for the decision of some senior doctors – members of the NHS Pension Scheme – to retire early.
How can I calculate whether I’m likely to breach the LTA?
To calculate the LTA at retirement, take the amount of pension income that you would expect from a DB scheme and multiply it by 20. This will give you a notional “pot” value, explains Pete Glancy, head of policy, pensions and investments at Lloyds Banking Group. It’s a lot simpler for DC schemes, he adds, where you simply look at the actual value of the pot.
“Of course, many people will have worked across both the private sector and the public sector during their working lives,” Glancy notes.
It’s actually very difficult for people to determine if they’ll have an issue with the LTA, he adds.
“You would need to contact the administrator of each pension scheme for each employer with whom you worked in the past, ask them to provide an illustrated value of the benefits and then apply some complex maths, which includes assumptions about investment growth and inflation.”
It’s best to work with a professional financial adviser who can do all of this for you. Financial advice comes at a cost, but you could avoid tax penalties that potentially amount to tens or even hundreds of thousands of pounds.
When might I have to pay the LTA charge?
The LTA applies to the value of all your pensions, except for the State Pension. Only the funds that exceed the LTA limit are subject to the charge, not the whole fund.
The LTA charge is applicable when certain conditions are met. First, if you die before the age of 75 and your funds have not been accessed at all. Second, if you reach age 75 and you haven’t accessed your funds or they’re in pension drawdown. Third, if you decide to take pension benefits, either in the form of a tax-free lump sum, a regular sum, or pensions drawdown. Or finally, if you transfer your pension funds overseas.
According to HM Revenue and Customs data obtained by the pensions consultancy LCP, more than 325,000 people have registered for protection against the LTA since 2006. However, only about 4,000 have applied for protection this year. As a result, some who can benefit could face unnecessary tax bills, LCP warns.
Matthew Arends, head of UK retirement policy at Aon, says reducing the LTA would potentially open a new swathe of UK pension savers to a pensions tax charge. This is particularly true for private sector employees saving into a DC pension.
“As the assessment of the LTA is more generous to DB pensions than DC pensions, this creates a disparity between the public and private sectors,” he says. “The most likely mitigation action for those with DB pensions would be to consider retiring early, if a reduction would be applied to the pension to reflect the early payment. There are no mitigation actions for DC pensions.”
Again, this is a complex area in which you should seek financial advice.
How can I lower the risk of breaching the LTA?
“Mitigating the size of the tax penalty could involve changes in the amount you save into a pension, versus other savings products such as ISAs,” says Glancy. “Alternatively, it could involve changes to the way in which your money is invested. Or it could involve changes to the timing and phasing of your retirement. These are complex considerations and unique to each individual’s circumstances.”
“Those that find themselves on or close to the threshold should consider whether it makes sense to divert some of their savings to another tax-effective savings vehicle, such as an ISA, to avoid penalties of up to 55% for breaching this limit and making withdrawals,” says Savova.
Claire van Rees is pensions partner at Sackers, a specialist law firm for pension scheme trustees, employers, corporate investors and providers. She says taking action to avoid going over the LTA isn’t necessarily the right thing to do.
“Stopping contributing to a pension if you’re close to the LTA won’t necessarily be the best financial decision,” she says. It could mean losing out on employer contributions to a DC pension arrangement, while those in DB schemes could be better off building up pension benefits and paying the LTA charges. However, everyone’s personal financial circumstances are different, so it’s important to take financial advice if you’re considering this course of action.
DB pensions are tested against the LTA by multiplying them by 20, so someone could have a DB pension of around £50,000 without exceeding the current LTA, she says. However, it would cost someone with a DC pension a lot more than £1.07m to buy a guaranteed income of £50,000 from an insurance company as annuity rates have fallen a lot over recent years.
“It is very difficult to protect against the LTA because one cannot predict investment performance and in a DB scheme this might mean retiring early to ensure the calculation basis is fixed now,” says Ros Altmann, former pensions minister and expert commentator for Pension Playpen. “But then that prevents all ongoing pension accrual and has done damage to the NHS, too. In the end, if there is a generous employer contribution and higher rate tax relief, it may still be worth incurring an LTA charge.”
Can I protect myself against a cut in the LTA?
If you think your pension fund might breach the LTA, you can apply for protection from the government. There are two types of protection.
Fixed protection 2016 allows you to fix your LTA at £1.25m, under the condition that no further pension contributions can be made.
Individual protection 2016 is for people whose pension was worth over £1m when the LTA was cut. You can continue to save but you may have to pay tax when you take your pension benefits.