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Pension lifetime allowance – what it is and how to calculate it

The pension lifetime allowance is the total amount of money that can be invested into your pensions in your lifetime by you, your employer, or any third party before you have to pay tax. In this blog, we will explore how this lifetime allowance works, how you can find out how much of it you have already used, and how it can be protected.

How does pension lifetime allowance work?

Most of us have it, but many of us are not even aware of it. Your pension lifetime allowance is £40,000 per annum. Over the average lifetime, it refers to the projected value of your pensions (excluding your state pension) and is a considerable amount – some £1,073,100. This is the allowed total, tax-free, as of the 2020/2021 tax year. It is frozen until the 2025/2026 tax year, when it will be next reviewed.

Your pension lifetime allowance refers to the total projected worth of private pensions into which the aforementioned parties have made contributions, but it does not include your state pension.

How the UK pension lifetime allowance is calculated

In answer to the question of how is the pension lifetime allowance calculated, at present, it is based on annual contributions up to a maximum of £40,000. Providing this total is not exceeded, it qualifies for the full tax relief. 

If, for example, you pay tax at the basic rate (20%), any contributions up to the maximum are subject to a 20% “discount.” So, as an example, if you earn £35,000 per annum, you can contribute £28,000 (£35K less 20%) tax-free. 

If you happen to be a higher-rate taxpayer, you must claim any relief through a self-assessment tax return form.

Does pension lifetime allowance include growth? Yes, it does. It is the estimated final value of your pensions that is considered when checking to establish whether you will have to pay tax. More about this is below in the How to check your current pension lifetime allowance section.

When checks are made into your UK pension lifetime allowance

You can pay as much as you want into your pensions, but checks are carried out at specific intervals to ascertain whether your total pension benefits have exceeded the current pension lifetime allowance. Typically, checks are carried out:

  • When you begin to draw a defined benefit pension
  • When you withdraw a lump sum or an income from a defined contribution type pension
  • If a pension is moved overseas before you reach the age of 75
  • On your 75th birthday, if you haven’t withdrawn anything
  • If you die before reaching 75 and haven’t accessed your pensions

Normally, once you have passed your 75th birthday, no further checks are carried out into your UK pension lifetime allowance.

But what happens if you go over the pension lifetime allowance is that any excess will probably be taxable.

How to check your current pension lifetime allowance

When you begin to receive your pension, the value of any withdrawals will be subtracted from your lifetime allowance and will normally be shown on your pension statements. For many people, the UK pension lifetime allowance is irrelevant, but it is worth estimating the value of the withdrawals you anticipate making in your retirement to try and steer clear of any potential charges. The bigger your pension pot, the more valuable this exercise could be. 

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Taking defined contribution pensions into account

Most of us have what are termed “defined contribution pensions”, the values of which are determined by the size of the contributions and how the investments they were used to purchase have fared. This is the value that will be used to compare against your pension lifetime allowance every time you withdraw money from your pension account.

Taking defined benefit pensions into account

With defined benefit or final salary pensions, their values are based on your salary, and how many years you worked for the employer. You calculate the value of defined benefit pensions by multiplying your anticipated annual pension by 20. Any tax-free lump sums must also be included in the figures.

Pension lifetime allowance protection

If you are concerned that you might have or are due to exceed your UK pension lifetime allowance and you fear you might end up with a nasty tax bill, you need to monitor how your pensions are performing to try to ensure you don’t exceed the thresholds. But you do have other ways to protect your pension lifetime allowance

You can apply for protection against the recent drops in terms of the lifetime allowance in the face of the fact that you might have been contributing to your pensions while aiming for a higher allowance. Two types of current protection exist, which now replace previous options.

Fixed or individual protection 2016 for your pension lifetime allowance

If your pension(s) is valued at over £1 million as of the 5th of April 2016, you can consider applying for fixed or individual protection 2016. They offer protection for your UK pension lifetime allowance either as at its value on the 5th of April 2016 or to a total amount of £1.25 million, whichever is higher. 

If you would like to find out more about the pension lifetime allowance projections available, you can talk to the HMRC Pensions Helpline on 0300 123 1079. There is no application deadline.

Will the pension lifetime allowance increase in the future?

As mentioned in the earlier section about how the allowance works, the UK pension allowance mechanism was frozen in 2021. Legislation was introduced to suspend the allowance’s link to the Consumer Price Index for five years, after which time the current allowance of £1.073 million will be reviewed.

What to do if you are in danger of exceeding your pension lifetime allowance

Now, you know the answer to the question of how pension lifetime allowance works, you’ve checked the predicted value, and you think you are in danger of exceeding it. Don’t just follow a knee-jerk reaction and stop or limit further contributions; chat to a pension specialist first.

If you do exceed your allowance, you could face:

  • A 55% tax bill on any lump sum you withdraw over and above the allowance
  • A 25% tax bill on any income you take over and above the allowance

When to talk to a pensions specialist

We hope that the pension lifetime allowance explained here in this blog answers all the questions you had about this benefit. However, it is quite a complex subject and, of course, an extremely important one, so if you still have some questions you need answering, we recommend that you talk to a private pensions’ specialist.

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