The pension lifetime allowance (LTA), set at £1,073,100 for the current tax year, can potentially have a big impact on our wealth planning – yet it’s a topic many of us may not know much about, given the complexity of how it is applied.
The LTA is the limit to how much you can build up in a pension, that is tested, over the period of your lifetime, while still enjoying full tax benefits. Here, we’ll be exploring how this allowance may impact you, based around these four key areas: the limit, testing, a lifetime and tax.
The £1,073,100 figure is set by the government, though to put it into context it has changed 11 times since the LTA was first introduced in 2006 at an initial level of £1.5m. It’s been as high as £1.8m in April 2010, and as low as £1m in April 2016. Since April 2018, the LTA has increased in line with the consumer price index (CPI)with CPI, until the last tax year where it is now frozen until 2026. It’s worth bearing in mind then that the limit could change again as you progress towards your retirement.
While the headline figure for the lifetime allowance will likely attract the most attention, it’s also important to think of it in percentage terms. Each withdrawal from your pension will trigger a test of the LTA (more on this later), and the total must not exceed 100% of the current limit. As you can see from the example in the table below, withdrawing the same amount from your pension will be a different percentage every time the LTA changes, and therefore use more, or less, of your available allowance. Changes to the lifetime allowance could work in your favour if the LTA starts to rise again in the future or they could work against you, if the LTA is reduced. It is worth noting that each time the government has reduced the LTA it has offered a form of protection at the higher level.
A £100,000 uncrystallised pension fund lump sum Uncrystallised Funds Pension Lump Sum (UFPLS) over different tax years
In order to work out the percentage used you simply divide the monetary amount (in this case £100,000) by the LTA of the tax year in question. So, for 2012, we have divided £100,000 by £1,800,000, meaning we used 5.5% of the LTA. A reduction in the lifetime allowance means that withdrawals of the same monetary value in 2016 and 2022, used a greater percentage of LTA. Someone making all three of these withdrawals, without any form of lifetime allowance protection, would have used 22.8% of their lifetime allowance.
What does testing mean in relation to the LTA. Pension scheme administrators are subject to legislation around what is referred to as benefit crystallisation events (BCE). These are specific occasions, when they must check whether the pension benefits arising (crystallising) at that point exceed a member’s available lifetime allowance.
The most common benefit crystallisation events are: designating funds into drawdown, accessing tax free cash, a scheme pension coming into payment and a pension holder reaching age 75.
When a BCE occurs, the scheme administrator compares the value of the member’s pension benefits to the member’s LTA that is still available. Any crystallising amount that exceeds the level of LTA available is subject to tax under the LTA charge.
There are 13 different BCEs, which take into account different personal circumstances and scenarios. If you’re unsure which may apply to you, a financial adviser could help you understand your circumstances.
So, what do we actually mean by ‘lifetime’? It is not widely understood when the lifetime allowance tax charge is paid.
I have clients come to me and say: “my pension is approaching £1m and I want to avoid the tax charge,” but they’re in their 40s or early 50s. If you are wise, you can defer paying an LTA tax charge until age 75, which is 20 years away for those reaching retirement age this year.
The lifetime for the LTA is mainly a concern for individuals between the age of 55 and 75; this is known as the ‘crystallisation window’, or retirement. This is because, for most people the standard retirement age is 55 (rising to 57 in 2028), and they cannot take benefits from their pension – either through buying an annuity, going into drawdown or withdrawing tax free cash – before this time. Age 75 is known as the ‘final test’, where all remaining uncrystallised pensions are tested, as well as investment growth within a drawdown plan. After age 75, there is no lifetime allowance test on your pension. So, when it comes to the lifetime allowance, the lifetime is a potential 20-year period between age 55 and 75.
There are, of course, exceptions to this rule when a benefit crystallisation event may occur prior to age 55, and therefore the “lifetime” is extended. The first is the transfer of your pension overseas. If you move your pension overseas, it is tested against the current LTA at that point in time. And the second, is if you pass away before 55 and your pensions are fully tested against the LTA before being distributed to your beneficiaries.
Although age 75 is known as the ‘final test’, there is a rare test that could occur after age 75. This tests the annual increase of a scheme pension in payment, however margins for increase apply.
The rate of tax you pay on your pension investments above the lifetime allowance depends on your circumstances. You may be familiar with the 55% tax charge for lump sums and 25% for income, but not have a grasp of which action falls into which category.
The lump sum LTA tax charge is less common. For this to be paid you have to take your uncrystallised LTA excess as a lump sum. Put simply, if you are £100k over the LTA, you pay a 55% tax charge in one go and receive a £45k net lump-sum payment.
The 25% tax rate is applied to income in excess of the LTA. This is applied to scheme pensions, annuities, the designation of funds into drawdown and is the tax charge applied at age 75 for benefit crystallisation events.
It is worth noting that marginal rate of income tax is then charged when your income option comes into payment, these are 20%, 40% and 45%. Within a drawdown option, you can manage your subsequent withdrawals to stay within your basic rate band and personal allowance. This way you can keep the aggregate tax charges below that of the lump sum lifetime allowance tax.
I like to refer to the LTA tax charge as ‘pensions capital gains tax’. Investing in a pension is incredibly tax efficient and with tax efficient products there is usually a cap on the full tax benefits available, for pensions that is the lifetime allowance. With the monetary figure frozen for five tax years, many more retirees will find themselves breaching the limit.
Pension planning in regard to the lifetime allowance can be complex, and this blog only scratches the surface of some of the areas that you may need to consider. Everyone’s circumstances are different; from relationship status, and number of dependents, to taxpayer status, as well as everyone having different retirement goals.
If you have questions about your own financial strategy, book a call with one of our wealth managers to understand your options.
We hope you have found this blog useful. Here are some key takeaways to remember:
- The LTA limit should be thought of in percentages. The monetary figure can change.
- The lifetime allowance is tested at crystallisation events, not once your pension reaches a certain value.
- The definition of ‘lifetime’ under the LTA lifetime in question typically ends at age 75 and may not start until retirement age.
- The lifetime allowance tax charge can be thought of as is ‘pensions capital gains tax’,
- Would you rather have a percentage of something or 100% of nothing.
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. A pension may not be right for everyone and tax rules may change in the future. If you are unsure if a pension is right for you, please seek financial advice.