How to avoid lifetime allowance charges is still an important question, despite the fact that the pension lifetime allowance itself will be abolished in April 2024. It’s a fairly complex subject, and we hope to make it easier to understand in this insight blog.
When it comes to saving for retirement, there are many different kinds of tax-efficient pension options, from traditional pension schemes to ISAs and Self Invested Personal Pensions (SIPP). While the concept of a SIPP is similar to that of a Stocks and Shares ISA, there is a difference between SIPP and ISAs: through SIPPs, you can get tax relief on your pension contributions relative to your income tax band. For basic rate taxpayers, this is essentially a 25% bonus from the government that’s added to each contribution. These tax benefits apply as long as you don’t exceed your SIPP lifetime allowance,
The NHS pension lifetime allowance (LTA) is the maximum amount of pension benefits you can accumulate while still receiving all available tax benefits. This includes self-employed pensions and deferred state pensions as well. Once you reach retirement age and begin accessing your pension benefits, you will incur an LTA tax charge on the surplus if you exceed the allowance during the tests performed by the HMRC. But how to beat the lifetime allowance? Read on to find out
| Is it worth paying the lifetime allowance charge? | Paying a small amount of additional tax may be worth paying if the net returns on savings that exceed the allowance are still higher than savings made elsewhere. |
| What happens when you exceed LTA? | When the HMRC finds that you’ve exceeded your LTA, you will typically incur a tax charge on the surplus if you exceed the allowance at specified times. |
| Will lifetime allowance increase with inflation? | In the 2022-2023 tax year, the HMRC set the lifetime allowance at £1,073,100, fixed at this rate until the 2025-2026 tax year, rather than rising with inflation as has previously been the case. However, it has since been announced that from April 2024, the LTA will be entirely abolished. |
How do I avoid the lifetime allowance charge?
The best way to know how to avoid pension lifetime allowance charges on LTAs is to make sure that at the times during which the HMRC checks the total value of your pension funds, the value does not exceed the lifetime allowance limit of £1,073,100. That’s why once you reach your 50s or become a higher earner, it’s also important to remember to make the most of your £20,000 ISA allowance, and find the right balance between your ISAs and pension schemes.
To avoid paying the lifetime allowance charge, it’s crucial to keep an eye on the value of your pensions if you wish to avoid incurring a penalty. In particular, watch out for increases in the value of any defined benefit pensions you might have, as these can grow significantly.
If your projected pension savings are forecast to surpass the lifetime allowance barrier, you may consider filing for pension lifetime allowance protection. There are two types of HMRC LTA protection that you can apply for – Individual Protection 2016 and Fixed Protection 2016, which work to raise the threshold of your LTA.
Individual Protection 2016
Individual Protection 2016 offers a personal lifetime allowance up to a maximum of £1.25 million that is equal to the value of your pensions on 5 April 2016, the day before the lower limit went into effect. Individual Protection 2016 (IP2016) is only accessible if your pension savings were worth more than £1 million on April 5, 2016.
Fixed Protection 2016
When applying for Fixed Protection 2016, there is no minimum pension worth requirement. As a result, the lifetime allowance you receive is either £1.25 million or the current lifetime allowance, whichever is higher. In specific situations, it is possible to lose this protection.
When it comes to how to avoid a lifetime allowance tax charge being made, the above-mentioned protections significantly raise the threshold. You can apply for and verify protections from the decrease in lifetime allowance at gov.uk
What is tested against the lifetime allowance?
The HMRC conducts these tests routinely at specific intervals during your life. Checks are frequently made when you accept an income or lump sum from a defined contribution pension when you begin drawing a defined benefit pension. In addition, the test will be implemented on your 75th birthday, whether you’ve received benefits or not.
The HMRC will test not just the lump sum or income amount that is paid to you, but the worth of the overall amount you are accessing. This then constitutes a percentage of your lifetime allowance. Any untouched pensions or pensions that have already been put into drawdown are valued when a test is performed at age 75.
If you’ve accrued more than the lifetime amount when the check is made, you might have to pay a tax penalty.
Will lifetime allowance be abolished?
The lifetime pension allowance was introduced in April 2006. When it was introduced, the limit was £1.5 million. According to the Consumer Prices Index, it has risen and fallen over the years in conjunction with inflation. Examples of changing lifetime allowance include when it peaked at £1.8m in 2012 before falling and reaching a low of £1m in 2016/17.
In the 2021/22 tax year, it was announced that this lifetime allowance pension limit would be fixed at £1,073,100. Is it worth exceeding the lifetime allowance is a question many people have asked, and when the old charge was in place, for most, it wasn’t, as they would have been handed a bill for 25% or 55% depending on whether money was drawn down or taken in a lump sum.
However, in April 2023, the LTA charge was replaced by income tax at the recipient’s marginal rate, and from April 2024, the lifetime allowance itself will be abolished.
Although the lifetime pension allowance UK charge was abolished, you can still use the fixed and individual protections 2016 discussed above to avoid lifetime allowance charges. If you haven’t already done so, you have up until the 5th of April 2025 to apply.
Does taking tax free cash affect lifetime allowance?
The normal rule is that the maximum tax-free cash (TFC) is 25 percent of the pension value, up to a lifetime allowance cap of 25 percent (LTA). However, tax-free cash can be safeguarded, and the type of LTA protection held can have an impact on how TFC is determined.
How does HMRC calculate lifetime allowance?
Your annual pension multiplied by 20, along with any lump sums you receive from the plan, are added to determine your lifetime allowance. The tool will not take into account any pension you are currently receiving or any pension you have with other pension plans.
Can I take 25% of my pension tax-free every year?
As long as there is money in your pension fund, you can withdraw it whenever you need to. How much and when you take it is entirely up to you. 25% percent of any lump payment you get is tax-free. However, once you take a lump sum, the pension fund becomes crystalised, and the remainder, when withdrawn, will be added to any other taxable income and will be taxed accordingly.
Is it better to take a higher lump sum or pension?
Whether the excess is received as a lump sum or as income will determine how the charge is applied. If you withdraw a lump sum or income from your pension fund, transfer money abroad, or reach the age of 75 with unused pension benefits, you will typically have to pay taxes on the excess if you go over the allowance.
There will be tax to pay on the surplus if the lifetime allowance is exceeded by the whole amount of your pension benefits at the time a check is made. We refer to it as the lifetime allowance charge. Whether the excess is received as a lump amount or as income will determine how the charge is applied.
The excess is taxed at a rate of 55% if you take it out in one lump payment. The tax should be withheld by your pension administrator or provider and paid to HMRC before the remaining amount is given to you.
When you keep the money in the pension scheme, in order to take regular income from it, there is a 25% tax charge. This applies when kept in a pension drawdown, an annuity, or other pension scheme. This is in addition to whatever income taxes you may owe on the money you earn when you earn it.
If you have a defined benefit pension plan, your pension plan may decide to pay the tax on your behalf and deduct it from your benefits in the future.
For defined contribution pension plans, your pension scheme administrator should deduct the 25% tax from your pension pool and pay it to HMRC. Compared to the lump sum tax rate of 55%, this will leave you with 75% to use as a source of retirement income.
Does an inherited pension affect lifetime allowance?
Even if they were formerly part of your pension fund, any assets you have when you pass away, such as cash or savings, will be considered part of your estate for inheritance tax purposes.
Any pensions you have can often be left to future generations outside of your estate and won’t be liable to inheritance tax. However, for this to be the case, the pension plan administrator would need discretion over who receives payments. Those who inherit a pension may need to pay a lifetime allowance on the amount they receive if it causes them to exceed their allowance.
How does lifetime allowance work with drawdown?
If you use your money to set up a flexible retirement income (known as pension drawdown), any money you still have in the pension when you reach age 75 will be checked again. If the money has grown so it is more than you had when you first moved into pension drawdown, (ignoring any tax-free lump sum you took at that time), this will use up more of your lifetime allowance.
Frequently Asked Questions
How much is the lifetime allowance?
Most people had their lifetime allowance frozen at £1,073,100 from the tax year 2022–2023. However, from the 5th of April 2024, it will be abolished.
What is LTA Protection?
There are two types of lifetime allowance protection that you can apply for – Individual Protection 2016 and Fixed Protection 2016, which work to raise the threshold of your LTA.
What is a pension drawdown?
When you use your pension benefits to set up flexible retirement income, this is called a pension drawdown.
*Capital at risk. Tax treatment depends on your individual circumstances and may be subject to change in the future.
