You can only save a certain amount each year, and over your lifetime, into pensions and still receive tax relief. Breaching these limits may see you subject to additional tax charges. Here, we explain what you need to know.
The pensions lifetime allowance is the total amount you can save in all your pensions without triggering additional tax charges when you withdraw the money.
The lifetime allowance applies to the value of all your pensions, aside from the state pension. This may include, for example, a self-invested personal pension (Sipp), workplace pensions, including defined-benefit or final-salary pensions, and any other personal pensions you have contributed to over the years.
The majority of people will find their lifetime allowance is £1,055,000 in the 2019-20 tax year. This is an increase from the £1,030,000 allowance in the previous tax year, but remains far off its peak of £1,800,000 in the 2010-11 tax year. The dramatic reduction in the lifetime allowance over recent years means more people are breaching the limit and incurring a tax penalty.
Patrick Connolly, chartered financial planner at Chase de Vere, says: “The cuts we’ve seen in the lifetime allowance mean that an increasing number of people will need to plan their pension arrangements very carefully, and more people, especially high earners with defined-benefit pension schemes, will have to pay a lifetime allowance tax charge.”
Some people may have a higher personal lifetime allowance as they have taken advantage of certain lifetime allowance ‘protections’ that have been made available over the years. You can find out more information on these at gov.uk/guidance/pension-schemes-protect-your-lifetime-allowance.
When you access your pension, the value of your total pot is assessed against the lifetime allowance. Any benefit over this amount is subject to tax. You should receive a statement from your pension provider letting you know how much tax you owe, with any charge taken from your pension benefits before they are received.
The amount of tax you pay on pension savings above your lifetime allowance depends on how you draw the money. Any excess will be taxed at a rate of 25 per cent in addition if drawn as income, such as benefits taken from an annuity or flexible drawdown arrangement, or 55 per cent if you take it as a lump sum.
Staying within the lifetime allowance limit
Making sure you aren’t breaching the lifetime allowance isn’t always easy, particularly if you’re keeping track of several different pensions, and your employer is also making contributions. Ensure any provider you have is sending regular statements to enable you to monitor your balances and take action if you’re approaching your allowance limit.
If you are unsure about whether you will be affected by the lifetime allowance, it may be wise to seek advice from your provider or a financial adviser. Bear in mind that as a long-term savings commitment, you could find you breach the lifetime allowance on your pension pot by the time you draw benefits, even if this wasn’t anticipated.
If you have been contributing to a money purchase, or defined-contribution pension, such as a Sipp, the value is simply the total amount that will fund retirement.
However, it may seem tricky to estimate the value of your pension if you’re a member of a defined-benefit or final-salary scheme, but there is a formula. This can be calculated by multiplying the value of the pension you will get in the first year by 20, plus your tax-free cash lump sum, according to the Pensions Advisory Service.
There are various steps you could take if you find you are approaching the limit for the lifetime allowance, but which is the right one for you depends on your personal circumstances and stage of life. You need to think carefully before making any decisions that could impact on your retirement provision.
For example, you may simply stop contributing to your pension, and consider other investments to save for the long term, given the tax-efficient options outside a pension (see below).
Alternatively, depending what age you are, you may choose to take your pension earlier than expected, as you can access this from age 55 (rising to 57 in 2028). If you are approaching retirement and paying into a personal pension, such as a Sipp you may want to reconsider your investment strategy to produce more moderate returns to help you stay within the limit for retirement.
Remember that you do not automatically pay a penalty when you breach the limit, as it is only when you draw money from your pension that your pot is tested against the lifetime allowance. The focus should be on how much you need for your retirement income, say experts. Beware of putting the brakes on valuable employer contributions, for example.
Mr Connolly stresses: “While paying a tax charge is far from ideal, the key for an individual should be the amount of pension they actually receive. It may seem counterintuitive to suggest any action that will knowingly lead to a tax charge, but the relative merits need to be weighed up.
“For example, it may be better to benefit from ongoing employer contributions to a pension and achieve say, a £1.5m pension pot against which a tax charge will be applied, than to stop employer contributions and limit the pension pot to £1m to avoid the tax charge.”
These considerations will vary depending on the person, of course, which is why professional financial advice is particularly important when considering the impact of the lifetime allowance and what is the best option for you.
The pensions annual allowance
Most people will have to consider the pensions annual allowance at some stage, currently set at £40,000 a year, or your earnings for the year, whichever is lower. This is the maximum amount you can contribute to your pension per year to receive tax relief at your personal rate.
When you pay into a pension you receive government tax relief at 20 per cent on your contributions, provided they are within the annual and lifetime limits. Higher-rate taxpayers who pay income tax at 40 per cent on a portion of their earnings can claim a further 20 per cent tax relief through their tax return. Meanwhile, additional-rate taxpayers, who pay 45 per cent tax on their top earnings, can claim an additional 25 per cent.
The annual allowance includes all payments into pensions, such as contributions to workplace or personal pensions, employer contributions and government tax relief. If you exceed the annual allowance you will not receive any pensions tax relief on contributions over the limit and face an extra tax bill on the extra contributions, known as the annual allowance charge. The charge will be at your personal tax rate, and added to the rest of your taxable income for the year when this is calculated.
There are some strategies that may help if you are struggling to stay within your annual allowance. Jo Douglas, of financial planner Brewin Dolphin, suggests: “Limit any future contributions to whatever is being matched by an employer if you’re in a group scheme. You may as well make the most of this benefit.
“If you’re contributing extra by topping up your pension, for example, you may want to look at alternatives that receive tax relief, such as your spouse’s allowance, once you’ve maxed out your allowance.”
People aged under 75 with no earnings are also eligible for basic-rate tax relief of 20 per cent on pension contributions up to £2,880 a year, boosting this to £3,600. This includes a spouse who isn’t working, for example, and children, and could provide a significant increase to retirement savings over time.
The tapered allowance
The tapered pension allowance was introduced for high-earning professionals in April 2016. This restricts the amount people earning more than £150,000 can receive in tax relief on pension contributions each year, on a sliding scale.
The tapered allowance includes a wider range of earnings that are considered income, explains Nathan Long, senior analyst at Hargreaves Lansdown. “The definition of income includes variable payments such as dividends, employer pension contributions, bank interest, rental income, bonuses and unapproved share schemes, meaning it can be challenging for many individuals to know their total income and if the reduction applies before the end of the tax year,” he says.
Higher earners have their £40,000 allowance reduced by £1 for every £2 of income above £150,000. The maximum reduction to the pensions annual allowance is £30,000, making the lower limit a higher earner may have as an annual pension allowance £10,000. For example, anyone earning over £210,000 will have an annual allowance of just £10,000, and will not receive any tax relief if this is breached.
Doctors and other senior medical professionals are among those who have reportedly been breaching the allowance by working overtime, with the tapering of the annual allowance alongside the lifetime allowance prompting some to cut their working hours, or even take early retirement.
However, the government has recently agreed to change the system for senior medical professionals, enabling them to alter their contributions into the NHS pension scheme to reduce or avoid potential tax charges. They will be able to select a level of pension benefit at the start of the year, with employers having the option to convert any unused contribution back into their salary.
The government has also agreed to reconsider the tapered allowance for NHS workers, and across the public sector.
Mr Long says: “The proposals will give far greater flexibility to the level of benefits that senior clinicians can build up. This won’t prevent their pension allowances being reduced if they earn more by working additional hours, but limiting their pension means they can avoid unexpected tax charges.”
The government has also agreed to reconsider the tapered allowance for NHS workers, and across the public sector. However, the announcement has been widely criticised for failing to address an overcomplicated system and leaving the rules unchanged for other high earners.
Mr Connolly says: “The system has become unnecessarily complicated. The introduction of the tapered annual allowance in particular, and the money-purchase annual allowance have caused great confusion.”
The money-purchase annual allowance may impact you if you have started to draw down from a Sipp or defined-contribution pension, aside from your 25 per cent cash lump sum. Your annual allowance in these circumstances may fall to just £4,000. It applies to those with flexible access to their pension scheme and may be triggered if, for example, you take drawdown income.
Avoiding the taper charge
The tapering of the annual allowance for higher earners risks catching out a lot of people, aside from senior medical staff, given it includes a wide range of income, alongside employer pension contributions. However, there are ways around the reduction with some savvy planning.
For example, you may be able to ‘carry forward’ any unused annual allowance from the previous three years at the end of the tax year. Bear in mind, however, that you must earn at least the amount you wish to contribute in the tax year that you do it to benefit from tax relief, unless your employer is making the contribution. You must also have used up your allowance for the current tax year before using allowances from previous years.
Alistair McQueen, head of savings and retirement at Aviva, says: “You can do this provided you were a member of a registered pension scheme in the carry forward years, and you did not maximise pension contributions in those tax years.
“You take the difference between the annual allowance for the carry forward year – tapered, if necessary – and your pension contributions in that year. Anything left over can be added on to the current year’s allowance.”
If you’re in this situation and carry forward is not available or sufficient enough to boost your pension, there are other steps you could take.
Mr Long says: “The first thing to do is approach your employer. Many employers operating modern defined-contribution pensions allow you to reduce the amount you pay into your pension by taking cash in lieu of the pension contribution. This isn’t true of all employers, and in particular those offering a defined-benefit pension may be more restrictive.
“However, for those who receive cash in lieu of a pension contribution, it’s important to ensure enough money is still being squirrelled away for retirement.”
Considering other investments
If you are a higher earner, and have more to invest after meeting your lifetime and annual allowances, you could focus on other investments. For starters, you can invest in individual shares or funds within an individual savings account (Isa) wrapper, depending on your confidence and preferences, to shelter gains away from UK tax. The Isa allowance stands at £20,000 in the 2019-20 tax year.
Mr Long says: “You could invest in a Lifetime Isa [for those who are under 40] as part of retirement planning, for example, which attracts a 25 per cent government bonus.” Up to £4,000 a year can be invested in a Lifetime Isa, as part of your Isa allowance.
Depending on your tolerance to risk and approach to investing, there are also more complex options that may be of interest, says Ms Douglas. “If you have maxed out your pension allowance and used your Isa allowance, you may want to look at other tax structures,” she says.
“For example, you could consider enterprise investment schemes (EISs), venture capital trusts (VCTs), or the seed enterprise investment scheme (SEIS) for income tax relief. But these typically come with much higher risk compared with pensions – depending on how your pension is invested. There may be liquidity issues, and other risks to consider, but if you are comfortable, you could consider these options.”
These are considered to be specialist, high-risk investments as they focus on small companies with shares that may be illiquid and tricky to sell.
Up to £200,000 a year can be invested in VCTs, with 30 per cent income tax relief that can be claimed back, provided the investment is held for at least five years. In addition, any profits are free from capital gains tax (CGT).
By contrast, up to £1m per year can be invested in an EIS, and shares must be held for a minimum of three years for the same 30 per cent income tax relief on investments, with gains also free from CGT.
Mr Connolly says: “VCTs also provide tax-free dividends, while EISs allow capital gains tax deferral and can also provide inheritance tax savings.”
t is possible to invest in a professionally managed VCT or EIS fund that includes a range of qualifying companies to spread risk.
The Seed Enterprise Investment Scheme, as its name suggests, is designed to help smaller, higher risk companies raise finance, and offers even more attractive tax reliefs, but these investments are considered particularly high risk.
Before investing outside a pension for retirement, make sure you understand what you are investing in and the capacity for growth over time. Beware of letting the tax tail wag the investment dog.
The many changes to pension rules over recent years, including to the annual allowance and lifetime allowance, have generally made pension planning far more complex. The right decisions for people will depend on their own individual circumstances, which is why it is really important that people seek professional financial advice if they are unsure of their situation and their tax liabilities.