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How to avoid breaching the lifetime allowance

The pension lifetime allowance rose by £18,100 to £1.0731 million in April 2020. While this is good news, the fact remains that a growing number of people are breaching the allowance and facing a 55% tax charge on any withdrawals they make from pension savings above this amount. If the excess is taken as an income, the tax charge reduces to 25%. Here, we discuss the various options you have for protecting your pension against the lifetime allowance.
Published on 21 September 2020

Although £1.055 million may seem an unattainable figure, 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 £365,000 could already be on track to breach the lifetime allowance by the age of 67.*

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.

Do nothing

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.

Retire early

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.

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What about savers with defined contribution schemes?

If we assume that someone has a pension fund of £1.055 million and they are aged over 55, then they could potentially release their full tax-free cash entitlement of £263,750 and retain the remaining £791,250 in income drawdown. This would use all of their lifetime allowance with no 55% tax charge.

The remaining £791,250 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 £791,250 at the time of the next Benefit Crystallisation Event, no lifetime allowance tax charge would be incurred.

Advice on lifetime allowance protection

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.

For more information about  the lifetime allowance in general, download Tilney's free lifetime allowance guide or book a no-obligation consultation with a financial planner from our wider Tilney Group. Complete this short online form on the Tilney website or call us on 020 7189 9999..

Important information

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 2019 (in line with the bank of England’s target rate of inflation) with a compounded annual investment return of 5% net of costs. 

*We have based this assumption on the premise that the lifetime allowance will continue to be increased each tax year in line with consumer price inflation (CPI). In this example we have used a CPI rate of increase of 2% p.a. with a compounded annual investment return of 5% net of costs.

**If you are in receipt of a defined benefit pension at age 75, an exceptionally high increase on it would be tested against the lifetime allowance, although this occurrence is rare.

Examples of how tax or tax relief may apply are based on our understanding of current tax legislation. Whether any tax will be payable, at what level it is charged and whether you qualify for tax relief will depend upon individual circumstances and may be subject to change in the future. This article does not constitute personal advice. If you are unsure as to any course of action, please talk to an adviser.