The Lifetime Allowance Explained
What you need to know and what you need to do about the Lifetime Allowance
A tax charge which was expected to only affect a small minority of wealthy savers, the Lifetime Allowance is now a mainstream consideration when planning for retirement that is likely to affect more than 1 million people.
What is the Lifetime Allowance (LTA)?
Your income in retirement, if it is to be more than just the state pension, is likely to come in large part from either money purchase pension scheme(s) to which you have contributed while working and/or final salary scheme(s) managed by your employer(s) in the private or public sector.
If you take pension income and/or lump sums that are calculated to be worth more than an amount known as the Life Time Allowance (currently set at £1,055,000 for the 2019/20 tax year), then for all amounts withdrawn in excess of this allowance a tax, known as the Lifetime Allowance Charge, is applied of 25% if withdrawn as income, or 55% if withdrawn as a cash lump sum.
How to calculate the Lifetime Allowance
In order to calculate whether you could be impacted by this tax, you should consider all types of pensions you have:
personal pensions, pensions arranged via your employer and final salary pensions, including public sector schemes like those operated by the NHS and Local Government. The only pension to exclude is that provided by the State.
- First, estimate the future value of all your money purchase pension funds, being their current value plus forecasted contributions and investment growth until the time that you plan to start drawing on them for retirement income (this is know as going into “drawdown”).
- Then, look at the projected annual income due to be paid on any final salary pensions you have. Multiply this annual income figure by 20 and add it to any lump sums you are entitled to from the final salary scheme.
If the total of these two numbers is £1 million or more then, depending on how and when you take your retirement income, it is possible that you will exceed your LTA at some point in the future.
Please note, this is a very simplistic approximation of a complicated calculation, normally done by a specialist, and doesn’t include for example any pensions that you started to take income from before 6th April 2006 or pensions that have been sold for an annuity.
What happens if you exceed the Lifetime Allowance?
There are two occasions on which the charge would be triggered:
- When your withdrawals exceed 100% of your calculated allowance
You will not use any of your allowance until you start withdrawing either income or a lump sum as tax free cash from one or more of your money purchase schemes or start taking income from a final salary scheme. This will prompt a calculation that will give you a percentage of your allowance that you are deemed to have used.
When the value of the pension benefits that you have taken exceeds 100% of your calculated allowance then tax becomes payable on all future withdrawals.
- The Lifetime Allowance Test at age 75
In view of the above, you might be thinking that the best way to avoid this tax is to minimise the withdrawals from your pension savings, which is why the LTA test is applied to everyone at age 75. This test measures the (tax free) increase in the value of your pension fund(s) since they went into drawdown (i.e. declared by you as a fund from which you wished to take retirement income). If you are not using the funds for retirement income, then investment returns are likely to increase their value which is deducted from any remaining LTA you might have. Any surplus amount will then be taxed as a lump sum at a rate of 55% or 25% if taken as income.
Lifetime Allowance examples
Example 1 – No withdrawal (retirement) income
David wanted to take £350,000 in tax free cash when he was 67. He therefore crystallised £1.4 million in October 2009 at age 65 (he is required to crystallise 4 times the amount of any tax-free cash). His £1.4m less the £350,000 meant that £1.05m moved into drawdown which used 80% of the LTA which at that time was £1.75m.
In May 2019, Dave has an LTA test at age 75. He has taken no income from the funds he drew down and his fund has grown by £390,000 to £1.44m.
His remaining available LTA is 20% of £1.05m (the current LTA), or £210,000. The £180,000 excess (£390k – £210k) is subject to a 25% LTA charge if it’s taken as income. The scheme administrator pays this to HMRC as the income is drawn.
Example 2 – Taking withdrawal (retirement) income
Susan decided to drawdown funds worth £1.5m at age 63 in October 2007. She took £375,000 tax-free cash and moved £1.125m into drawdown, using 94% of the then £1.6m LTA.
In May 2019, Susan has an LTA test at age 75. She has been taking retirement income of around 4% a year – a little less than her investment gains and her fund is now worth £1.18m.
The growth on her drawdown fund is £1.18m minus £1.125m = £55,000, using a further 5.2% of the current LTA of £1.05m. As this is less than her 6.25% available LTA, there is no LTA charge.
Note how, in order to manage the various levels of LTA over the years, it is expressed in a percentage of the 100% allowed rather than an absolute amount, as is normal with most tax allowances.
What are my Lifetime Allowance options?
The immediate thought for many people when they realise that they are already over or close to the limit is to stop paying into pensions. That might be right for some people, but it may not be the best solution for others.
If for example you are still working and your employer is making pension contributions on your behalf, then you are effectively receiving free money. Even if this free money takes you over the pension lifetime allowance it’s better to receive 45% (after lifetime allowance tax) of the free money rather than nothing at all.
You should seek expert advice about the different forms of transitional protection that can be obtained, and which serve to lessen the adverse impact of the several reductions that have been made to the LTA in recent years.
A Financial Model, created using sophisticated software, is the best way to forecast your financial future and create a variety of scenarios that show what any future tax implications might be. The most important advice is not to panic, if you are still several years away from retirement then, working with an expert, you should monitor your LTA situation on an ongoing basis.
To find out more about planning for your retirement, please visit our Retirement Planning page.
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Book your free meeting today, to find out how we can help you manage your Lifetime Allowance situation.