With a sig­nif­i­cant pro­por­tion of the UK pop­u­la­tion fac­ing a short­fall in retire­ment income, the gov­ern­ment has used tax breaks to encour­age long-term pen­sion sav­ing. How­ev­er, those sav­ing too much could face a poten­tial tax charge of up to 55% if their fund val­ue breach­es an upper lim­it, known as the pen­sions Life­time Allowance (LTA). 

Under the cur­rent rules, which remained large­ly untouched by today’s Bud­get, savers are allowed to make an annu­al pen­sion con­tri­bu­tion of 100% of their income, capped at £40,000 per per­son per year. Those that have fol­lowed the advice and made large, reg­u­lar con­tri­bu­tions to their pen­sions could fall foul of the LTA should they save more than £1m in their pen­sion pot.

How much can I save in a pension before extra tax charges?

The LTA lim­it has been reduced and frozen sev­er­al times and there is dis­cus­sion of lim­it­ing this even fur­ther. One leaked pro­pos­al is to reduce it from just over £1m to around £800,000 in the Autumn Bud­get on Octo­ber 27. Any funds above this thresh­old would be sub­ject to 55% tax if with­drawn as a lump sum, or 25% if paid as income. This will effec­tive­ly draw many more pen­sion savers into the LTA net.

The LTA cap was first intro­duced in 2006, when it was set at £1.5m. The thresh­old was increased in 2010 to £1.8m, before being reduced to £1m in 2016.

It has since risen in line with infla­tion, with the thresh­old cur­rent­ly £1.073m. It has been frozen at this lev­el for at least the next five years, a mea­sure announced in the March 2021 Bud­get.

Why does the LTA matter?

Broad­ly, there are two types of pen­sion. A Final Salary or Defined Ben­e­fit (DB) pen­sion – com­mon in the pub­lic sec­tor – pays a pro­por­tion of your for­mer salary when you retire. 

A Mon­ey Pur­chase or Defined Con­tri­bu­tion (DC) pen­sion is found more often in the pri­vate sec­tor, and sees con­tri­bu­tions from you and your employ­er invest­ed on your behalf. The val­ue of those invest­ments is the pot of mon­ey that you can then use to gen­er­ate an income through retire­ment.    

A pen­sion fund of £1m may sound like a lot, but if you have a pri­vate pen­sion that will only buy you an annu­al income of just over the annu­al aver­age salary in the UK. 

“Using cer­tain esti­mates, a £1m pen­sion would rough­ly gen­er­ate a £35,000 annu­al income, which is not an exces­sive amount for many retirees who find them­selves free from work and look­ing for­ward to enjoy­ing their retire­ment,” says Romi Savo­va, CEO of Pen­sion­Bee.

One of the anom­alies in the rules is that the LTA cap hits those with a pri­vate sec­tor pen­sion or per­son­al pen­sion hard­er than some­one who has a pub­lic sec­tor pen­sion. Nev­er­the­less, the LTA was blamed for the deci­sion of some senior doc­tors – mem­bers of the NHS Pen­sion Scheme – to retire ear­ly.

How can I calculate whether I’m likely to breach the LTA?

To cal­cu­late the LTA at retire­ment, take the amount of pen­sion income that you would expect from a DB scheme and mul­ti­ply it by 20. This will give you a notion­al “pot” val­ue, explains Pete Glan­cy, head of pol­i­cy, pen­sions and invest­ments at Lloyds Bank­ing Group. It’s a lot sim­pler for DC schemes, he adds, where you sim­ply look at the actu­al val­ue of the pot. 

“Of course, many peo­ple will have worked across both the pri­vate sec­tor and the pub­lic sec­tor dur­ing their work­ing lives,” Glan­cy notes.

It’s actu­al­ly very dif­fi­cult for peo­ple to deter­mine if they’ll have an issue with the LTA, he adds. 

 “You would need to con­tact the admin­is­tra­tor of each pen­sion scheme for each employ­er with whom you worked in the past, ask them to pro­vide an illus­trat­ed val­ue of the ben­e­fits and then apply some com­plex maths, which includes assump­tions about invest­ment growth and infla­tion.”     

It’s best to work with a pro­fes­sion­al finan­cial advis­er who can do all of this for you. Finan­cial advice comes at a cost, but you could avoid tax penal­ties that poten­tial­ly amount to tens or even hun­dreds of thou­sands of pounds.

When might I have to pay the LTA charge?

The LTA applies to the val­ue of all your pen­sions, except for the State Pen­sion. Only the funds that exceed the LTA lim­it are sub­ject to the charge, not the whole fund.

The LTA charge is applic­a­ble when cer­tain con­di­tions are met. First, if you die before the age of 75 and your funds have not been accessed at all. Sec­ond, if you reach age 75 and you haven’t accessed your funds or they’re in pen­sion draw­down. Third, if you decide to take pen­sion ben­e­fits, either in the form of a tax-free lump sum, a reg­u­lar sum, or pen­sions draw­down. Or final­ly, if you trans­fer your pen­sion funds over­seas.

Accord­ing to HM Rev­enue and Cus­toms data obtained by the pen­sions con­sul­tan­cy LCP, more than 325,000 peo­ple have reg­is­tered for pro­tec­tion against the LTA since 2006. How­ev­er, only about 4,000 have applied for pro­tec­tion this year. As a result, some who can ben­e­fit could face unnec­es­sary tax bills, LCP warns.

Matthew Arends, head of UK retire­ment pol­i­cy at Aon, says reduc­ing the LTA would poten­tial­ly open a new swathe of UK pen­sion savers to a pen­sions tax charge. This is par­tic­u­lar­ly true for pri­vate sec­tor employ­ees sav­ing into a DC pen­sion. 

“As the assess­ment of the LTA is more gen­er­ous to DB pen­sions than DC pen­sions, this cre­ates a dis­par­i­ty between the pub­lic and pri­vate sec­tors,” he says. “The most like­ly mit­i­ga­tion action for those with DB pen­sions would be to con­sid­er retir­ing ear­ly, if a reduc­tion would be applied to the pen­sion to reflect the ear­ly pay­ment. There are no mit­i­ga­tion actions for DC pen­sions.” 

Again, this is a com­plex area in which you should seek finan­cial advice. 

How can I lower the risk of breaching the LTA?

“Mit­i­gat­ing the size of the tax penal­ty could involve changes in the amount you save into a pen­sion, ver­sus oth­er sav­ings prod­ucts such as ISAs,” says Glan­cy. “Alter­na­tive­ly, it could involve changes to the way in which your mon­ey is invest­ed. Or it could involve changes to the tim­ing and phas­ing of your retire­ment. These are com­plex con­sid­er­a­tions and unique to each individual’s cir­cum­stances.” 

“Those that find them­selves on or close to the thresh­old should con­sid­er whether it makes sense to divert some of their sav­ings to anoth­er tax-effec­tive sav­ings vehi­cle, such as an ISA, to avoid penal­ties of up to 55% for breach­ing this lim­it and mak­ing with­drawals,” says Savo­va.

Claire van Rees is pen­sions part­ner at Sack­ers, a spe­cial­ist law firm for pen­sion scheme trustees, employ­ers, cor­po­rate investors and providers. She says tak­ing action to avoid going over the LTA isn’t nec­es­sar­i­ly the right thing to do. 

“Stop­ping con­tribut­ing to a pen­sion if you’re close to the LTA won’t nec­es­sar­i­ly be the best finan­cial deci­sion,” she says. It could mean los­ing out on employ­er con­tri­bu­tions to a DC pen­sion arrange­ment, while those in DB schemes could be bet­ter off build­ing up pen­sion ben­e­fits and pay­ing the LTA charges.  How­ev­er, everyone’s per­son­al finan­cial cir­cum­stances are dif­fer­ent, so it’s impor­tant to take finan­cial advice if you’re con­sid­er­ing this course of action.

DB pen­sions are test­ed against the LTA by mul­ti­ply­ing them by 20, so some­one could have a DB pen­sion of around £50,000 with­out exceed­ing the cur­rent LTA, she says. How­ev­er, it would cost some­one with a DC pen­sion a lot more than £1.07m to buy a guar­an­teed income of £50,000 from an insur­ance com­pa­ny as annu­ity rates have fall­en a lot over recent years. 

“It is very dif­fi­cult to pro­tect against the LTA because one can­not pre­dict invest­ment per­for­mance and in a DB scheme this might mean retir­ing ear­ly to ensure the cal­cu­la­tion basis is fixed now,” says Ros Alt­mann, for­mer pen­sions min­is­ter and expert com­men­ta­tor for Pen­sion Playpen. “But then that pre­vents all ongo­ing pen­sion accru­al and has done dam­age to the NHS, too.  In the end, if there is a gen­er­ous employ­er con­tri­bu­tion and high­er rate tax relief, it may still be worth incur­ring an LTA charge.”

---

Can I protect myself against a cut in the LTA? 

If you think your pen­sion fund might breach the LTA, you can apply for pro­tec­tion from the gov­ern­ment. There are two types of pro­tec­tion.

Fixed pro­tec­tion 2016 allows you to fix your LTA at £1.25m, under the con­di­tion that no fur­ther pen­sion con­tri­bu­tions can be made. 

Indi­vid­ual pro­tec­tion 2016 is for peo­ple whose pen­sion was worth over £1m when the LTA was cut. You can con­tin­ue to save but you may have to pay tax when you take your pen­sion ben­e­fits.

---