Even just a few years ago, getting caught by pension allowances was a preserve of the super-wealthy. Now, thanks to changes to the rules ushered in by successive governments, it’s easy to fall foul of some of the rules governing the tax position of your pension.
You only have to look at the news headlines concerning the pension issues faced by thousands of NHS staff to see the impact the Tapered Annual Allowance has had on higher earners. Plus, as pension wealth is increasing at a faster rate than inflation, more and more people are having to manage their pension arrangements to negotiate a possible Lifetime Allowance charge.
September 2019 figures from HMRC show a sharp increase in both the number of Lifetime Allowance charges paid, and the total value of those charges.
When it comes to retirement planning, it’s vital that you consider both the Tapered Annual Allowance and Lifetime Allowance. Here’s why.
The Tapered Annual Allowance
In an attempt to control the cost of pensions tax relief, back in 2016, the government introduced a reduced Annual Allowance that applied to higher earners, linked to their level of taxable income within the tax year.
Originally, this Tapered Annual Allowance affected individuals with ‘threshold income’ of more than £110,000 and ‘adjusted income’ of more than £150,000. However, after countless headlines about the impact this taper had on (mainly) public sector workers, the Chancellor announced changes to the taper in his 2020 Budget.
Since April 2020, the Tapered Annual Allowance now applies to individuals with ‘threshold income’ of more than £200,000 and ‘adjusted income’ of more than £240,000.
‘Threshold Income’ is broadly defined as ‘your net income for the year’. This will include all taxable income, such as:
- Salary and bonus
- Pension income, including the State Pension
- Trading profits
- Income from property
- Dividend income
- Onshore and offshore bond gains
- Interest from savings, distributions from authorised unit trusts and OEICs
Any taxable lump sum pension death benefits paid to you during the tax year can be deducted from your ‘threshold income’.
The ‘adjusted income’ definition adds in the value of all employer pension contributions. This is to prevent you from avoiding the restriction by exchanging salary for employer contributions.
If you’re in a Defined Benefit arrangement, the value of the employer contribution will be calculated using the Annual Allowance methodology. The employer contribution will be the total pension input amount for the arrangement, less the monetary amount of any contributions you make towards that arrangement during the tax year.
How the Tapered Annual Allowance works
Where you breach both the ‘adjusted income’ and ‘threshold income’, your Annual Allowance is reduced by £1 for every £2 that your ‘adjusted income’ exceeds £240,000. There is a maximum reduction of £36,000, down to a minimum Tapered Annual Allowance of £4,000.
- If your adjusted income is less than £240,000 your Annual Allowance will be £40,000
- If your adjusted income is between £240,000 and £312,000 your Annual Allowance will be between £4,000 and £40,000 (see below)
- If your adjusted income is more than £312,000 your Annual Allowance will be £4,000
The Lifetime Allowance
Of course, there’s no limit on the total pension fund you can save for your retirement. However, the Lifetime Allowance is effectively the maximum you can save without triggering any tax charges.
The Labour government introduced the Lifetime Allowance in 2006/07. Less than a decade ago it stood at £1.8 million but, since then, successive governments have reduced it so that it now stands at £1,073,100, increasing annually in line with the Consumer Price Index to reach £1,078,900 in 2021/22.
The Lifetime Allowance takes into consideration all your pension arrangements – Defined Contribution and Defined Benefit – but not your State Pension.
Defined Contribution schemes
For Defined Contribution schemes, such as personal pensions and most employer-sponsored schemes, you need to calculate the overall value of all your pension funds.
You’ll then need to consider how long you may have until you retire, and how much you’re currently contributing into your arrangements – more of this in a moment.
Defined Benefit schemes
For Defined Benefit (Final Salary) schemes the overall value is the pension you expect to receive when you retire, multiplied by 20, plus any tax-free lump sum.
Here’s an example. If the scheme you’re in will provide an annual pension of £50,000, together with three times the initial pension as a lump sum, the value you’ll need to consider is:
- 20 x £50,000 = £1,000,000
- 3 x initial pension as lump sum = £150,000
- Total = £1,150,000
There is no immediate charge when your overall pension fund grows above the Lifetime Allowance. The charge is only levied when you begin to draw pension income, and is only calculated at specific times, which are known as Benefit Crystallisation Events.
These events are typically when you take any income or lump sums from your pension fund, at age 75, and upon death.
If the value of your total pensions exceeds the Lifetime Allowance when the calculation is made, you will pay a tax charge of:
- 25% of any amount over the Lifetime Allowance taken as regular income
- 55% of any amount over the Lifetime Allowance you take as a lump sum.
Why it’s easier than ever to face Lifetime Allowance charges
Even ten years ago your pension fund would have needed to be substantial before you started having to worry about potential Lifetime Allowance charges. Now, however, it’s increasingly easy to be affected by the allowance.
For example, if you’re in a Defined Benefit/Final Salary scheme, your pension would only need to be projected at around £47,000 a year for you to reach the current Annual Allowance.
And if you had £750,000 saved in a Defined Contribution scheme, at an annual growth rate of 4% a year the value of your fund would exceed the Lifetime Allowance in ten years’ time.
If you assume a 6% annual growth rate over the next decade, you’d reach the current Lifetime Allowance with just £620,000 invested in your fund.
Bear in mind also that these examples don’t take into account any regular contributions you may still be making.
Of course, the Lifetime Allowance will rise annually over the next ten years. However, with pension wealth growing faster than inflation, you’re still likely to find yourself facing allowance issues in the future.
Seek professional advice
Rules governing pension allowances are complex and getting it wrong can be extremely costly. This is why it’s so important to seek professional advice when you’re approaching your retirement.
For example, it is possible to protect your Lifetime Allowance, and therefore avoid the tax charges outlined above. This is especially worth considering if you are already over the Lifetime Allowance limit, or very close to it.
However, applying for protection will likely mean that you can no longer make any further pension contributions. This will obviously impact on your financial planning – particularly how you fund your income in retirement – so speak to a financial adviser before making any decisions.