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When a million pounds is not enough: Coping with the lifetime pension allowance

Friday 22nd January 2016

Written by Martin Upton

From April this year the lifetime allowance on the size of individual pension funds falls from £1.25 million to £1 million. Holdings beyond this limit will be taxed at 55% when drawn out. 
This is the third cut in the lifetime allowance since 2011/12 when the allowance stood at £1.8 million and the move is aimed at curtailing the growth of tax relief on pensions.
Such a punitive tax rate will surely discourage the build-up of pension pots beyond the £1 million limit. It may seem that a £1 million limit will only apply to a small number of affluent pension savers and that the related tax risk is not something the general public should feel they will be exposed to. 
However this is not the case. With those starting to build up a pension fund early on - and particularly where they are in schemes where their employers contribute too – the risk of breaching the current lifetime allowance is a real threat. There is a particular risk to those with defined benefit pensions. With these the annual pension is multiplied by 20 to determine the pension benefit crystallisation amount. So a £50,000 annual pension counts as £1 million for the lifetime allowance. 
The government’s own figures show that some 55,000 people have pension funds of between £1 million and £1.25 million. These will therefore find themselves breaching the allowance when the new limit takes effect in the 2016/17 tax year unless they seek protection from the rule change (see below). However analysts believe that the number of people at risk of eventually exceeding the £1 million limit is in the hundreds of thousands. 
Certainly those paying into schemes from an early age may end up being penalised for their prudence and forward planning by seeing the value of their pension assets exceed the lifetime allowance.
Some employers may now consider schemes which help prevent their staff breach the lifetime allowance – for example by paying additional salary rather than paying in contributions to pension schemes. Since the highest rate of income tax is 45% this would clearly be a tax efficient move if it prevents withdrawals from pension schemes being taxed at 55%.
Alternative measures to avoid the 55% tax could include simply stopping paying into pension schemes or retiring early – although such moves fly in the face of prudent financial management and the freedom of choice about when to retire. Additionally if you stop paying into an employment-based pension your employer will stop paying in too.
A better idea could be to take 25% of the pension assets as a lump sum at the point of retirement and invest the residual, assuming together they are below the £1 million limit, using the returns generated from the investment fund as income. 
It is crucial to make sure that enough income is drawn to prevent the value of the fund growing before the age of 75 is reached. The residual amount would not be subject to a further lifetime allowance check until the age of 75 or until it is used to buy a lifetime annuity. The 25% drawn upfront can also be invested with the returns generated being outside the pension scheme and, hence, unaffected by the lifetime allowance. 
Investing the money in ISAs, where returns are tax-free, would be a sensible option – although this would have to be done in stages given the annual limit (currently £15,240) on ISA investments.
Those affected by the reduction in the allowance can seek the protection under the existing limit of £1.25 million. But if they do this then they must stop contributing to their pension fund. If they do continue to contribute the protection will be lost and the lower limit of £1 million will take effect.
The maths and the related decisions are complex. The rule surely has to be to take advice on an issue that, without careful planning, may see people recouping only 45% of part of the pension pots they have conscientiously built up through their working lives.
*Martin Upton is Director of the True Potential Centre for the Public Understanding of Finance (True Potential PUFin)

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