On 6 April 2016 the pension lifetime allowance will reduce from £1.25 million to £1 million, meaning more people will be subject to the 55% tax charged on withdrawals of any pension savings in excess of the allowance.
Although £1 million may seem an unattainable figure, Tilney Bestinvest research has shown that many savers in the middle of their working lives could actually be on track to breach the allowance without investing another penny.In fact, a 30 year old with a pension pot of £360,000 could already be on track to breach the lifetime allowance by the age of 65.*
Unless you have previously secured Enhanced Protection on your lifetime allowance, there is no guarantee that a 55% tax charge can be avoided. However, there are several options for people with defined benefit pensions that may help to avoid or reduce this tax.
The first course of action is to do nothing and simply pay the tax charge if there is anything above the lifetime allowance. However, some members of final salary pension schemes may be reluctant to continue paying into their pensions in this way if they will receive only 45% of the benefits for their contributions.
Opt out of your defined benefit pension arrangement
Another option is to opt out of the defined benefit pension scheme and avoid accruing any benefits in future. This can help to avoid paying the 55% lifetime allowance tax charge, although it is rarely advisable to give up the benefits offered by such a pension scheme.
Many defined benefit pensions will offer a reduced level of income if you begin taking benefits before reaching the scheme’s normal retirement age. In such cases, retiring early and taking a lower annual income could potentially mean you reduce the value of your pension below the lifetime allowance and will pay no 55% tax charge.
Take the maximum tax-free cash entitlement
Some defined benefit pension arrangements will pay a tax-free lump sum in addition to an annual income. However, many people are not aware that they can actually take more tax-free cash by commuting part of their pension entitlement (subject to an overall maximum). Commutation factors will differ between pension schemes, but as long as yours is below 20 you will be able to reduce the overall value of your pension benefits – for lifetime allowance purposes – by taking the maximum tax-free cash lump sum available.
What about savers with defined contribution schemes?
If we assume that someone has a pension fund of £1.25 million and they are aged over 55, then they could potentially release their full tax-free cash entitlement of £312,500 and retain the remaining £937,500 in income drawdown. This would use all of their lifetime allowance with no 55% tax charge.
The remaining £937,500 remains invested and would only be subject to a further lifetime allowance check if the individual were to die, purchase an annuity or remain in drawdown on their 75th birthday (these are known as Benefit Crystallisation Events). In any case, the tax charge would only apply to any growth the fund has returned since it entered drawdown.
However, income withdrawn from the pension would not be subject to a lifetime allowance check, so an individual could simply opt to withdraw the growth in the pension fund as income (albeit subject to Income tax). As long as the fund value remains below £937,500 at the time of the next Benefit Crystallisation Event, no lifetime allowance tax charge would be incurred.
We would like to see the highly punitive lifetime allowance scrapped, as it penalises decent investment performance and is a deterrent to some people saving for retirement. However, as the rules currently stand we would urge those who believe they may breach the lifetime allowance to seek professional financial planning advice, especially given the complexity involved.
The value of investments, and the income derived from them, can go down as well as up and you can get back less than you originally invested. This article does not constitute personal advice. If you are in doubt as to the suitability of an investment please contact one of our advisers. Prevailing tax rates and reliefs are dependent on your individual circumstances and are subject to change.
Before transferring pensions, you should ask yourself: Will I be charged or penalised by my existing provider for transferring? Will I lose any valuable features or benefits if I transfer? Have I considered my current pension charges, and could consolidating be more expensive? Am I part of an occupational final salary pension scheme? (In which case I would most likely be better off not switching).
*We have based this assumption on the lifetime allowance becoming inflation-linked and increasing by 2% every year from April 2018 (in line with the bank of England’s target rate of inflation) with an compounded annual investment return of 5% net of costs.