A lifetime pension allowance limits the sum of money that you can withdraw from your pension without incurring additional tax charges from HMRC. The lifetime allowance is applied to all pensions you have, which can be defined benefit or final salary schemes. However, your state pension is excluded by the allowance.
How Much is the Lifetime Pension Allowance?
For the 2021/2022 tax year, the lifetime allowance stands at ?1,073,100 for most people and applies across the total amount in any pensions you have. This value will remain fixed until at least the 2025/2026 tax year but could extend beyond then, depending on the financial climate at that time.
While there is no limit on the sum you can build up in pension benefits during your lifetime, you will be liable to pay a tax charge if you exceed this amount.
Checks are regularly carried out on the money you have accrued in your pension funds to determine whether you have exceeded the limit. These checks generally occur when you start drawing a defined benefit pension, when you take a lump sum from such a pot if you move the pension abroad before the age of 75, if you haven’t touched your pension by the age of 75 or if you die before 75 without touching your retirement fund. After your 75th birthday, checks on your pension generally cease.
What are the Charges for Exceeding the Lifetime Allowance?
If the total value of your pension is higher than ?1,073,100 when a check is carried out, you will be taxed on the excess. This fee is known as the lifetime allowance charge, and it varies depending on how you take the excess amount.
If you draw the excess from your retirement fund as a lump sum, it will be taxed at 55%. Generally, this will be automatically deducted and paid to HMRC by your pension provider or administrator before paying the excess out to you.
On the other hand, if you decide to leave the money in the pension and draw an income from it, you will be taxed differently. The tax will be applied whether you draw income from your retirement fund as part of a flexible arrangement, as an annuity or as a scheme pension.
You will be charged a tax of 25% on the amount that exceeds the lifetime allowance. In addition, this tax is on top of any income tax that you already pay on the income you receive. If you receive the income from a defined benefit pension scheme, the scheme managers might choose to pay the tax for you and then recover the amount by reducing the payout from the fund.
For a defined contribution pension scheme, the administrator should dispense the 25% to HMRC from your pension pot. This will leave you with the remaining 75% to use towards your income after retirement.
Overall, when the rates of income tax and the charge for exceeding the lifetime allowance are combined, they total 55%. This is the same value as someone who decided to take the amount as a lump sum would have to pay.
Will You Hit the Limit?
While the limit of ?1,073,100 might seem like an unattainable amount, many people at the midpoint of their working lives will be on track to breach it. For example, if you are 30 years old and your retirement fund is valued t ?270,000, you could be on the way to exceed the limit by the time you hit 67 years old. However, there are some steps that you can take to limit the liability you face by the time you retire.
Avoid Ceasing Payments
Generally, it is a good idea to continue to invest in your pension fund instead of ceasing payments for fear of exceeding the limit. Your pension fund will grow tax-free over time. This means that you do not have to pay income tax or capital gains tax on any money you invest into your retirement fund during your working life. This helps to boost the overall return that you can expect to see once you hit retirement age.
However, if you decide to stop contributing, your employer might also cease their contributions to the pot, which can be a lucrative source of retirement funds. Ultimately, this can leave you worse off than paying taxes on any money over the limit.
Your pension will provide support and protection for you and your family once you decide to stop working, so you should do all you can to ensure the amount in it is as large as possible, even if this involves going over the limit. To ensure that your loved ones are supported, you might also consider investing in relevant life insurance to protect them should you pass away before retirement age. If you are wondering, “how much does relevant life insurance cost?” check out this page for more information.
What You Can Do to Avoid Charges
One way that you might be able to reduce your tax liability after exceeding the lifetime allowance is to retire early. Many defined benefits schemes provide reduced income if you start to take payments from the fund before reaching the prescribed retirement age. If you decide to retire early and take a lower annual income, it is possible to reduce the value of your pension to below the lifetime limit. This can help you to avoid the tax charge altogether.
With a defined contribution scheme, the fund is tested against the allowance instead of the pension itself. This means that if you begin drawing from it at an earlier age, you can decrease the fund’s value because you will no longer be making contributions to your pension. As a result, this could also allow you to avoid paying the tax on any excess amount.
Another tactic you could use to avoid paying the fees for exceeding the limit is to wait longer to take your pension. The lifetime allowance does not apply after you have reached the age of 75. If you do not hit the limit before you get to this age and you haven’t taken anything from the fund, you can keep it invested and let it grow further. This can take your pension fund to a value exceeding the limit, but you will not have to pay tax on it since you are over the age at which it crystallizes. This can be a particularly valuable strategy if you have other forms of income you can rely on before hitting the age of 75 or if you plan on passing your pension on after your death.
Conclusion
Overall, the lifetime pensions allowance represents a set amount that your retirement fund cannot exceed before the age of 75. If the value of your pension increases beyond this, you are liable to pay tax on any amount above ?1,073,100. You can take some steps to reduce the amount you will forfeit to HMRC, however, and in some cases, avoid it altogether. As a general rule, you should keep a close eye on the value of your pension pot and implement measures as needs be to reduce your liability.
