Lifetime Allowance planning

The Lifetime Allowance (LTA) is the total amount of money you can build up in your pension accounts without paying extra tax charges. If you go over the LTA, you will pay a tax charge on the excess whenever you take income or withdraw a lump sum from your pension, or reach the age of 75 without having taken any benefits.

When the Lifetime Allowance was introduced in the 2006/2007 financial year, the threshold was originally £1,500,000. However, since then, the LTA has been reduced significantly, meaning those who are currently saving for retirement should plan ahead to avoid being taxed on their pension savings. It’s important to understand how and when the LTA test is applied, and what pensions are included in the LTA calculation.

In this article, we take a closer look at how the Lifetime Allowance works and discuss various strategies that could help you protect your pension savings from excess tax charges.

For the 2021/2022 tax year, the Lifetime Allowance is £1,073,100.

This means that if the value of all your pension pots exceeds this amount, you will have to pay Lifetime Allowance tax charges on the excess. There are a number of scenarios that trigger a tax charge, including taking money out of your pension, transferring your pension overseas, or turning 75 without having taken any benefits from your pensions.

While the LTA has been increased in line with CPI inflation in recent years it has been reduced significantly since its peak of £1,800,000 in the 2011/2012 year, as can be seen in Figure 1. In the 2021 Budget, the link to the CPI increase was removed, freezing the LTA until April 2026.

Tax Year	Lifetime Allowance
2006/2007	£1,500,000
2007/2008	£1,600,000
2008/2009	£1,650,000
2009/2010	£1,750,000
2010/2011	£1,800,000
2011/2012	£1,800,000
2012/2013	£1,500,000
2013/2014	£1,500,000
2014/2015	£1,250,000
2015/2016	£1,250,000
2016/2017	£1,000,000
2017/2018	£1,000,000
2018/2019	£1,030,000
2019/2020	£1,055,000
2020/2021	£1,073,100
2021/2022 (frozen until 2025/2026)	£1,073,100

Source:https://www.gov.uk/government/publications/rates-and-allowances-pension-schemes/pension-schemes-rates

As a result, many investors, particularly higher earners, are increasingly breaching the LTA limit.

The rate of tax you’ll pay if your pensions exceed the LTA threshold will depend on how you withdraw your money from your pensions.

If you take any excess amount above the Lifetime Allowance as a lump sum it will be taxed at 55 percent. However, if you take the excess amount as income, it will be taxed at 25 percent. This tax will be in addition to regular income tax. 

Withdrawal method	Tax rate
Lump sum payments	55%
Income payments	25%

The Lifetime Allowance applies to the value of all your pensions. This includes defined benefit (final salary) pensions and defined contribution pensions. However, the LTA does not include the State Pension.

The amount that counts towards your Lifetime Allowance will depend on the type of pension you have and is calculated differently for defined benefit and defined contribution pensions, as shown in Figure 2.

Type of pension pot	What counts towards your lifetime allowance
Defined contribution - personal, stakeholder and most workplace schemes	Money in pension pots that goes towards paying you, however you decide to take the money
Defined benefit - some workplace schemes	Usually 20 times the pension you get in the first year plus your lump sum - check with your pension provider

Source: https://www.gov.uk/tax-on-your-private-pension/lifetime-allowance

Additionally, death-in-service benefits – employee benefits that are paid out as a tax-free lump sum if you are employed by the company at the time of your death – also count towards the LTA.

The total amount of all your pensions will be assessed for LTA purposes.

So, for example, if you have three defined contribution pension plans worth a total of £200,000 and you take a lump sum of £50,000, £200,000 will be tested against your Lifetime Allowance. In this scenario, you will have used up 18.63 percent of your Lifetime Allowance (the LTA is always rounded down to decimal places).

There are a number of scenarios that trigger a test against the LTA. These scenarios are known as ‘benefit crystallisation events’ (BCEs) and HMRC has defined 13 of them.

Some of the most common BCEs include:

• Accessing your pension savings to take a lump sum or income
• Turning age 75 and not having drawn any benefits from a defined benefit or defined contribution pension or having some pension funds in drawdown at age 75
• Transferring a pension to a qualifying recognised overseas pension scheme (QROPS)
• Receiving a lump sum death benefit before age 75

Here is a basic example of Lifetime Allowance tax charges in practice.

Charles has all of his pension savings in his Self-Invested Personal Pension (SIPP). He is 62 years old and has not previously taken any benefits from the SIPP.

Charles decides to retire and start taking pension benefits on 1 July 2021 when the value of his SIPP is £1,400,000. He decides to take the maximum 25 percent tax-free lump sum, and draw a flexible income via flexi-access drawdown from the remaining balance.

Pension value at benefit crystallisation date	£1,400,000
Lifetime Allowance	£1,073,100
Excess value	£326,900
Lifetime Allowance tax charge (£326,900 x 25%)	£81,725

Charles’ tax-free lump sum will be the lesser of:

1. 25 percent of the pension value at the crystallisation date (£1,400,000 x 25% = £350,000)
2. 25 percent of the Lifetime Allowance at the crystallisation date (£1,073,100 x 25% = £268,275)

In this scenario, Charles will receive a tax-free lump sum of £268,275 and will pay tax of £81,725.

When Charles turns 75, he will then face a further LTA test on the funds remaining in drawdown.

Now that we have covered the basics of the Lifetime Allowance, we will explain how you can prepare for it, and look at some simple strategies that can help you avoid crossing the LTA threshold.

The first step in planning for the Lifetime Allowance is to work out whether you are at risk of exceeding the threshold. The best way to do this is to calculate the total value of all your pensions now, and project the value to retirement.

Remember that for Lifetime Allowance purposes, the value of your pensions will be calculated differently depending on the type of pension. For a defined contribution pension such as a SIPP, the value is simply the balance in the account. However, for a defined benefit pension, the value is usually 20 times the pension you will receive in the first year plus any lump sums.

If you are still an active member of a defined benefit pension scheme, it will be difficult to predict what your final benefits will be, as they will be linked to your pensionable salary and the accrual rate under the pension scheme.

If you are unsure about how to calculate the total value of your pension accounts, don’t hesitate to speak to a financial planner.

Breaching the Lifetime Allowance is not always a bad thing. While you will pay a tax charge on the excess, you will get to enjoy the taxed extra benefits. However, if you want to avoid breaching the LTA threshold, there are a number of things you can do.

If you have a defined contribution pension that is nearing the LTA, one simple strategy that is worth considering is to divert money that you would have contributed into your pension into an Individual Savings Account (ISA). ISAs enable you to invest your money tax-free, yet any money in an ISA will not count towards your LTA. You can currently contribute £20,000 per year into an ISA. This strategy is not suited to those in defined benefit pension schemes as these individuals are likely to be better off continuing to accrue benefits within their scheme.

If you are married, one strategy that could help you avoid crossing the LTA threshold is to redirect your retirement savings into your spouse’s pension, as they will have their own separate Lifetime Allowance. This can be an effective way of avoiding the limit.

If you have a defined benefit pension, another option is to retire early. Many defined benefit pension providers will offer a lower level of income if you begin taking benefits before reaching the plan’s normal retirement age. As such, retiring early and taking a lower annual income could potentially help you reduce the value of your pension below the Lifetime Allowance. You could also ask the pension scheme if it offers the option to reduce the way you are accruing future benefits. If it does, you could continue to build up your pension but on a reduced basis.

Alternatively, you could consider delaying retirement or phasing your retirement benefits. Assuming that the LTA continues to increase in line with CPI in the future, this strategy could enable you to take advantage of a higher threshold, and, therefore, avoid or reduce tax charges.

Finally, it’s also worth investigating whether you are eligible for one of the Lifetime Allowance protections such as Individual Protection 2016 and Fixed Protection 2016.

Individual Protection 2016 is for investors who had pension savings of at least £1 million at 5th April 2016 and allows you to retain the lower of either your pension value at 5th April 2016 or £1.25 million. With this scheme you can continue saving into a pension above your threshold, however, any savings above the threshold will be liable for the LTA tax charge.

Fixed Protection 2016 provides you with a Lifetime Allowance of £1.25 million. However, you cannot apply for this protection if you have made any contributions to your defined contribution pension or further benefit accrual has occurred in your defined benefit pension scheme after 5th April 2016.

In conclusion, it’s important to be aware of the Lifetime Allowance and plan for it accordingly, as even pensions that appear modest today could exceed the LTA threshold in the future. You could face substantial tax charges if your pension exceeds the LTA when it is tested.

Taking steps to plan for the Lifetime Allowance in advance is a sensible idea. It may be necessary to stop contributing to your pension and instead, contribute to other investment vehicles, or perhaps even take your pension early to avoid being taxed excessively.

The tax rules regarding the Lifetime Allowance are complex, and we would urge those who believe that they may be at risk of exceeding the Lifetime Allowance to seek professional retirement planning advice.

To find out more about the Lifetime Allowance, or if you have any questions about financial planning, request a call back.