Most people have more pressing matters to worry about than whether their pension pot will exceed the Lifetime Allowance (LTA) - in fact, it almost sounds like a nice problem to have. But more than 1 million working people are at risk of breaching this allowance - and being landed with a tax bill.
The Lifetime Allowance is the upper limit on the total value of payouts that can be taken from all of your pension schemes without a tax penalty. According to a 2019 report by Royal London, as many as 1.25 million people still in work are at risk of breaching the LTA by the time they retire – and these are not business moguls or superstars, but ordinary working folk.
They fall mainly into two groups: longstanding and relatively senior public sector workers whose final salary pensions will be worth more than the LTA, and relatively well-paid workers in a workplace pension scheme – typically earning £60,000 to £90,000 – who receive generous pension contributions from their employer.
Ironically, as Royal London points out, “the very highest earners may be less affected by the lifetime cap, because they are now heavily limited in the amount they can put in to a pension each year” through rules that restrict the pension savings for ‘high earners’.
What is the Lifetime Allowance?
The Lifetime Allowance was introduced at £1.5 million in 2006 and rose to £1.8 million in 2010. Since then it has been successively cut, falling to £1 million in 2016. It has increased annually in line with inflation since 2018/19, and stands at £1,073,100 for the 2021/22 tax year.
But if we assume that pension pot values will tend to grow over time at a faster rate than the LTA, which rises only with inflation, the proportion of workers whose pensions are impacted is likely to increase over the years.
What does the LTA mean in practice? It is hideously complicated, but in a nutshell, if your pension pot exceeds that amount, you could become liable to a hefty tax charge on the excess when you receive payouts.
The LTA test is applied by the pension provider every time you access a pension – known as a benefit crystallisation event (BCE) – to calculate what proportion of your LTA you have used, and what’s left.
These BCEs (there are 13 in total) include taking out a tax-free lump sum, moving some or all of your pot into a drawdown account, buying an annuity and taking a one-off taxable lump sum. In other words, they cover just about every route for withdrawing money from a pension.
“Quite often two BCEs will happen at once – you might take a tax-free sum and go into drawdown, for example – so there’ll be two crystallisation tests done at the same time and your scheme administrator will give you a certificate showing the total amount of LTA you’ve used up,” explains Kate Smith, head of pensions at insurer Aegon.
She adds: “At age 75 there are separate crystallisation tests that take into account any unused funds in the pension pot, and also in your drawdown account. So even though your withdrawals up to then may not have exceeded the LTA, if your remaining funds (across all pensions) push you over the threshold at the age of 75, then you’ll be liable for a tax charge on the excess.”
Your death also triggers BCEs against any funds remaining in the pension pot, but this time they’re treated differently by your scheme administrator. The administrator pays out the full amount to your nominated pension beneficiaries (either as income or as a lump sum), and if an LTA charge is payable, they are responsible for settling it.
What if You Breach the LTA?
There are two ways the LTA penalty can be levied, depending on how you access the excess amount:
- If you take a cash lump sum, the pension administrator will take 55% of the amount above the LTA and pay it to HMRC before paying over the balance to you; there is no more tax to pay on that sum.
- If you want an income and are moving money into drawdown or buying an annuity, the administrator withholds 25% of the amount exceeding the LTA before allocating the balance. Then, when you draw an income or receive annuity payments, you pay tax as usual at your highest rate.
“Both routes work out roughly the same – a total 55% charge – for a 40% taxpayer,” says Smith. “However, the income option is more tax-efficient for a basic-rate taxpayer because they’ll pay less tax.”
Here's an example:
Say you withdrew £100,000 from your pension and the whole lot exceeded the LTA. If you took it as a lump sum, you would receive £45,000 after the 55% penalty.
If you opted for income drawdown, £75,000 would be paid into your drawdown account after the 25% penalty. Higher-rate taxpayers would then lose 40% of that as tax when they took income, ending up with £45,000 in income payments, while basic-rate taxpayers would lose 20%, receiving £60,000.
Can I Avoid Breaching the LTA?
If you’re concerned that your pension savings may exceed the LTA, the government currently offers a choice of two protection options:
- Fixed Protection 2016 can only be used if there have been no contributions to your pension pot since April 5, 2016, whether or not you’re still working. It enables you to fix your LTA at a higher level of £1.25 million, though the penalty charge will apply as usual to any pension savings you take above that.
- Individual Protection 2016 is available to those who had more than £1 million in pension savings on April 5, 2016, and gives them protection equal to the lower of the amount in their pension at that point or £1.25 million. They can carry on contributing under this scheme, but any additional contributions above that enhanced level will likely attract the penalty charge.
However, says Smith, some people do choose to continue building their pension and accept the fact that they will pay a penalty charge: “You still get tax relief on your contributions, and still benefit from employer contributions. What really matters, though, is what you’ll get back after the LTA charge has been deducted, and that’s not easy to work out. It’s a time when you do need help from a financial adviser.”
