When you save money into a personal or company pension, the government usually gives you tax relief on the contributions. In this way, people are incentivised to make financial provision for their old age.
But there is a limit to the state’s generosity, and the limit takes the form of a ceiling on the amount of money that can be held in a pension while continuing to benefit from these tax incentives. This is known as the lifetime allowance (LTA).
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The LTA was introduced in 2006 in a bid to cap government spending on pensions tax relief. At that point it was set at £1.5 million, and it rose steadily to reach £1.8 million by the 2010-11 financial year. Since then, however, the LTA has been steadily cut and it will be down to £1 million in 2016-17.
Even at £1 million, the LTA might seem very high and unlikely to have any impact on the majority of pension savers. But those who have paid decent amounts into a pension over many decades while enjoying relatively high rates of investment growth could easily amass a pension fund approaching this figure by the time they retire.
At the same time, workers who are part of generous workplace final-salary pension schemes could be even more liable to be affected by the LTA.
How does the lifetime allowance work?
When you take your pension – for example by using it to buy an annuity or enter a drawdown scheme – it is assessed to see if it exceeds the LTA.
Any excess will face a higher tax charge: this is currently set at 25% if the pension is taken as income (as it would be through an annuity or drawdown), or a much more punitive 55% for pension cash taken as a lump sum.
These tax charges come on top of any other income tax charges the income or lump sum might attract. If you have more than one personal pension, the combined value is used – but your state pension entitlement does not count towards the LTA.
Given the potential tax penalties, it is clear that care should be taken to ensure the LTA is not breached if at all possible.
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How the value of your pension is assessed
If you have one or more defined-contribution pensions – these are private or workplace pensions where you pay in a certain amount each month, but where the final value is based on the performance of your investments – then the total value of your funds is assessed when applying the LTA.
With final-salary pensions, however, a different calculation is used, since these pensions do not have a specific fund earmarked for each saver.
Instead, the government looks at the annual income provided by the final-salary pension and multiplies it by 20 to give an overall value for the purposes of the LTA assessment. Any lump-sum payment is added to this amount.
So for a final-salary pension paying £25,000 a year with a £120,000 initial lump sum, the total value would be £620,000.
As well as when you first take money from your pension, you may be assessed to see if you have breached the LTA on other occasions, for example when you turn 75, if you decide to transfer your pension overseas, and when you die.
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Action if you are nearing the limit
If you are in a defined-contribution pension, your fund could be driven towards the LTA by strong investment performance, not just the amount of money you pay in.
If you are nearing the LTA, as well as suspending your own contributions, you could consider switching your investments to lower-risk assets that focus more on protecting your capital rather than seeking high rates of growth.
In a final-salary scheme, significant pay rises towards the end of your career, while welcome in themselves, could risk pushing you towards the LTA. You may, therefore, wish to consider early retirement, for example.
Bear in mind that these are not simple decisions to make and there are a number of factors to weigh up. It is likely, therefore, to be worthwhile seeking expert, independent financial advice.
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Protection against falling LTAs
As the LTA has been cut over recent years, the government has given savers the option of protecting their allowance in a given year. This means that they can continue to benefit from a current, higher LTA even though the limit is subsequently to be reduced, as it was in April 2016, for example.
There are two types of protection: individual protection can apply when the size of the saver’s fund is already higher than the upcoming, lower LTA level (but less than the existing level). This means that savers can maintain the right to apply the higher LTA to their fund, thus potentially escaping excess tax charges in the future.
Alternatively, savers can apply for fixed protection regardless of the size of their fund: again, this means they can continue to benefit from the higher LTA. But this protection is lost if any further contributions are made to the pension.
The LTA is a particularly complex area of pensions policy and there is no one-size-fits-all solution: the most suitable approach will depend very much on your own personal circumstances. So, as mentioned above, anyone who thinks they could be affected by the LTA should definitely consider obtaining specialist independent advice.
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