Please note: This article was written in 2022, and the UK government has now abolished the lifetime allowance. We will be writing an updated guide imminently.
Recently there has been a lot of media coverage surrounding the Lifetime Allowance for pensions. In this article, we are sharing a video, one of our pensions specialists recently published on this topic.
You can watch the video below, or alternatively, we have published the transcript as an article.
What is the lifetime allowance for pensions, how is it calculated, and is inflation impacting it?
We have broken the video down into sections.
- What is the lifetime allowance for pensions?
- The current impact of inflation on the Lifetime Allowance
- How is the Lifetime Allowance for pensions calculated?
- The Lifetime Allowance test
- Planning ahead
- Other tax-efficient investments
What is the lifetime allowance for pensions?
This is effectively a cap on the amount of wealth you can accumulate in pensions in your lifetime.
You can breach this cap, but any excess is taxed quite heavily – up to 55%.
The cap currently sits at a level of £1,073,100.
The current impact of inflation on the Lifetime Allowance
In the past, the Lifetime Allowance has gone up annually in line with Consumer Price Inflation.
But, in the wake of government Covid spending, it will stay the same until 2026.
With inflation at such high levels, this freeze is effectively an annual reduction in real terms.
This has produced the same effect as the freezes on income tax thresholds and inheritance tax nil-rate bands.
This allowance isn’t concerned with how much you pay into your pension. It’s the total value of the benefits you’ve accrued that you need to look at.
Note: This article was published in March 2022 when inflation was high in the UK.
How is the Lifetime Allowance for pensions calculated?
The lifetime allowance includes:
- Money you’ve paid in
- Any money an employer has paid in
- Tax relief you received
- Any investment growth you’ve achieved
- Other income paid in – e.g share dividends / rental income
Any benefits in final salary or career average schemes need to be included too.
These schemes don’t have a fund value as such so there’s a calculation that works out how much your lifetime allowance these benefits take up.
Please note: Sterling & Law – Hampshire do not conduct final salary / defined benefit pension transfers
The Lifetime Allowance test
Tax isn’t applied automatically as soon as you breach the allowance.
There are certain events that will trigger what’s called a “Lifetime Allowance test” which is where the value of your fund is compared to the value of your unused allowance and any excess is taxed.
There is a whole list of these events which I’m not going to go into now, but the three main ones are:
- When you draw benefits from your pension
- Your 75th birthday
- On death
You might think this doesn’t apply to you because your fund is currently way below the limit but be careful.
A fund that’s only £660,000 today but growing at 5% a year will breach today’s lifetime allowance level within ten years.
And that’s without a single additional contribution going in!
Someone maximising their £40,000 annual allowance for contributions would only need a fund of only £375,000 today to exceed the allowance within ten years based on investment returns of 5% a year.
Plan ahead and seek independent financial advice
The biggest and best piece of advice I can give you is to plan ahead.
It’s so much easier to prevent a lifetime allowance problem from occurring than to try and mitigate one that’s already there.
Talk to an independent adviser who uses cash flow modelling or financial life modelling software to accurately predict if and when you’re likely to breach the lifetime allowance.
This takes the guesswork out of it. They’ll be able to create a number of scenarios based on different levels of contribution and different projected growth rates to show you the real picture.
If this shows you heading towards the cap, they’ll be able to model different potential ways of avoiding this and show you the long term implications.
That might involve taking benefits earlier than planned, for example, or reducing pension contributions and looking at alternative ways of accumulating benefits for retirement.
For example, could you increase pension contributions for your spouse or partner?
Maximised your pension contributions? How about other tax efficient savings and investments?
There are other ways to save and invest toward your financial future in a tax-efficient way.
- Enterprise Investment Schemes
- Venture Capital Trusts
Enterprise Investment Schemes (EIS)
Enterprise Investment Schemes, for example, often shortened to EIS, offer some very generous tax breaks.
They’re not for the feint-hearted, though.
The level of investment risk with these can be quite high so they’re not for everyone.
Venture Capital Trusts (VCTs)
Venture Capital Trusts or VCTs also offer income tax benefits.
These are designed to provide income rather than growth, but dividends are tax-free even for an additional or higher rate taxpayer which can present some interesting financial planning opportunities.
Like EIS investment the level of risk to capital can be significant so it’s important to take appropriate advice before investing in anything like this.
Start the pension planning process now
That’s the overriding message here – the sooner you look at your potential lifetime allowance situation the better.
Take independent advice, put yourself in an informed position and plan ahead.
Looking to speak to an experienced pensions adviser?
Sterling & Law – Hampshire offers independent pensions advice to a range of individuals.
We are FCA regulated, and highly experienced in devising tax-efficient investment and retirement strategies.
Call us now on 01329 550190 or send us an email to schedule a no-obligation call or meeting with one of our advisers.
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