If you are on course to pick up a retirement income of £50,000 a year or more from a final salary pension then you may face the prospect of seeing a slice disappear because of daunting taxes.
That’s because a legal cap on pension savings means a fund of more than £1 million means pension savings lose their tax-free protection when they pass through that ceiling. The government has imposed a lifetime allowance on pension funds of £1 million and a final salary retirement income of £50,000 a year is deemed as the maximum even though the fund has no real cash value.
Doctors, head teachers and public servants with middle or senior officer grades are all at risk and probably do not realise they will have to pay a 55% on any pension that tops the lifetime allowance.
Keeping tabs on your retirement savings
It’s easier to keep tabs on a defined contribution pension because the fund is assigned to the saver and the trustees must report the cash value to the saver with a statement each year.
But as final salary or direct benefit schemes report likely annual pension income rather than cash values, if you do not realise the £50,000 equals £1 million rule applies to you, it’s more difficult to see when the tax penalty starts to bite.
Some workers fear the tax consequences of breaking the £1 million limit so much, they retire early and risk missing out on valuable benefits.
If you are in a company scheme, other solutions include switching the cash to an offshore QROPS for expats. This is not an option for public funded pensions as a specific rule introduced a couple of years ago bans such transfers to protect the public purse.
Keep reading to find out more about the lifetime allowances rules and what you can do to minimise the Treasury’s tax take from your retirement pot.
What is the pensions lifetime allowance?
The lifetime allowance is simply the limit the government places on the amount a UK tax resident can save in a pension without triggering a tax penalty.
The allowance applies regardless of the type of pension a retirement saver has:
- For a defined contribution pension, which are mainly SIPPs and other personal pensions, the allowance is the value of the fund
- For a defined benefit pension, the fund value is 20 times the pension paid in the first year. That’s where the £50,000 a year figure comes from, as 20 times £50,000 is £1 million.
The lifetime allowance was introduced in April 2006 by Labour Chancellor of the Exchequer Gordon Brown.
The value has fluctuated since – from £1.5 million in 2006 to £1.8 million in 2010, then back to £1.5 million in 2012, to £1.25 million in 2014 down to the current £1 million.
In the future, the allowance will rise each April 6 in line with any rise of the annual Consumer Price Index rate in the previous September.
With each change in the lifetime allowance until April 2018, savers were offered ‘protection’ that allows them to keep their limit in force before the cut, providing they stopped contributing to a pension.
It’s important to realise the lifetime allowance is the total of all your pension savings and not a limit applied to each if you have more than one.
What happens when you breach the lifetime allowance?
If your pension savings top your lifetime allowance, a tax penalty is triggered against the amount above £1 million or your protected fund value.
Tax on a cash lump sum is 55% of the amount exceeding the allowance, while income is taxed at 25% plus any income tax normally levied on pension benefits.
Some savers take the view tax pension savings are OK, but you need to work out if putting the excess money elsewhere would offer a better return.
Basic rate (20%) taxpayers can manipulate the tax they pay on breaking the limit by taking more money as income rather than as a lump sum, as the tax is lower.
When is your pension tested by HMRC?
For retirement savers with final salary pensions, the scheme pays the tax on any lifetime allowance excess as a one-off payment and then claws back the money by reducing the amount paid in benefits.
Common times for HM Revenue & Customs to test the value of both defined benefit and defined contribution pension funds are:
- On access – either when transferring to a QROPS or other pensions and when withdrawing a cash lump sum or income
- At 75 years old
- On death
If you fear breaching the lifetime allowance, other than putting money into ISAs, it’s worth looking at the opportunities offered by the government’s tax-incentivised investment schemes for business, such as the Seed Enterprise Investment Scheme (SEIS), the Enterprise Investment Scheme (EIS), Social Investment Tax Relief (SITR) and Venture Capital Trusts (VCT).
Avoiding the double pension tax whammy as a high earner
Worries about breaching the lifetime allowance are bad enough for most retirement savers, but high earners on £150,000 a year face HMRC plundering their retirement savings twice.
Once you hit the £150,000 milestone, the annual allowance tapers by £1 for every £2 earned from £40,000 a year to £10,000. If you earn £210,000 a year or more the annual allowance sticks at £10,000.
The annual allowance is the maximum pension contribution attracting tax-relief a retirement saver can make into one or more pensions in a year.
Any annual contributions over that year’s cap are taxed at the saver’s marginal rate of tax, which is likely to be 45% for high earners, and if the fund value then exceeds £1 million, the 55% tax charge applies.
What can you do about pension tax?
The main point to think about is the net outcome rather than having sleepless nights about the amount of tax due.
The question is will you end up with more cash in the hand from overpaying into a pension rather than investing the same amount of money elsewhere?
The other factor is where do the pension contributions come from?
If they are employer-funded, the calculation is probably simpler than worrying about annual allowance taper relief.
Leaving the scheme early and then investing the money that would have gone into the pension in SEIS, EIS or a VCT seems sensible.
Taking an early cash lump sum has a dubious benefit as reducing the fund will impact any future income.
Say you have a fund of £875,000 that you feel will soon breach the lifetime allowance rules. You could take the 25% tax-free lump sum of £218,750, leaving a pot of £656,250 that is unlikely to tilt at the limit.
As your fund has never topped £1 million, no tax penalties are triggered.
Another way to save without hitting the limit is to consider contributing to a spouse pension or to retirement savings for children or grandchildren to take advantage of their tax reliefs and to distribute the cash before inheritance tax falls due. Contributions into other people’s pensions do not count towards the lifetime allowance.
Why is a QROPS a good choice for expats
Providing you are moving to a country where the overseas transfer charge doesn’t apply, your pension fund value is tested against the lifetime allowance on switching schemes, but can then grow without limit.
Shifting the same money between a defined benefit to a defined contribution pension onshore scheme will not achieve the same outcome as the lifetime allowance will still apply.
Depending on where you choose to live overseas, a QROPS can boost the value of your pension income as local income tax rules will apply to the payment of benefits and QROPS will pay out in local currencies as opposed to sterling.