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Lifetime Allowance and Final Salary Pensions

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    If you are considering transferring your Final Salary Pension, one thing you should make sure you are aware of is the Lifetime Allowance (LTA) and how it might affect you.

    What is the Lifetime Allowance?

    The Lifetime Allowance (LTA) is a limit on the value of payouts from your pension schemes that can be made without triggering an extra tax charge.

    Under current tax rules, you can build up a pension fund worth £1,073,100 million over your lifetime, for both final salary and private pension owners. If the Lifetime Allowance is exceeded, an additional tax bill is payable from your pension pot.

    It was reduced in 2016 and is currently set at  £1,073,100 . The Government has indicated that it will increase each year in line with inflation. Once you exceed this amount, you’ll pay 55% tax if you take your money as a lump sum or 25% tax if you take it as income.

    How is Lifetime Allowance Calculated for Final Salary Pensions?

    Lifetime allowance is calculated by your pension provider and is usually worked out on 20 times your first year’s pension plus your lump sum. This means someone with a £50,000-a-year pension income would still fall within the £1,073,100 limit and could avoid the tax.

    However, if they opt out of their pension and are offered a CETV greater than £1,073,100, they will trigger the LTA on anything paid out over that amount.

    If you do exceed the LTA, your Pension Scheme Administrator will take the tax from your pension as soon as you start drawing it. The amount you receive will be reduced accordingly.

    How much is the Lifetime Allowance in 2021?

    As of April 2020 the Lifetime Allowance is £1,073,100 an increase of 0.5% on the 2020 threshold. The LTA is due to rise in line with inflation to £1,078,500 for 2021/22.

    If you accrued more than £1.055 m in your pension pot before April 2016, you can apply to protect it against the reductions to the Lifetime Allowance that were introduced in 2016. Full details can be found on the government website.

    Defined Benefit and Lifetime allowance

    For those drawing a defined benefit (final salary pension) above the LTA, without any protection, the rate of tax you pay on pension savings above your lifetime allowance depends on how the money is paid to you.

    Current taxable rate over the LTA

    • 55% if you get it as a lump sum
    • 25% if you get it any other way, for example, pension payments or cash withdrawals

    This is on top of any tax payable on the income in the usual way. 

    Lifetime Allowance Income Examples 

    Suppose you pay tax at the higher rate and expect to get £1,000 a year as income. The 25% lifetime allowance charge will reduce this to £750 a year. After Income Tax at 40%, you would be left with £450 a year.

    lifetime allowance taken as income

    This means the lifetime allowance charge and Income Tax combined will have reduced your income by 55% – the same as the lifetime allowance charge had the benefits been taken as a lump sum instead of income.

    lifetime allowance paid as a lump sum

    How and when do I pay Lifetime Allowance tax

    For defined benefit pension schemes, your pension scheme administrator should pay the 25% tax to HMRC out of your pension pot, leaving you with the remaining 75% to use towards your retirement income. This will be collected at source by the pension scheme from day one of the pension payments.

    Those with Defined Contribution accounts valued at more than  £1,073,100 (or higher with protection) can defer the impact of the lifetime allowance to age 75.

    This can be achieved by keeping drawings within the LTA limits up to age 75 and gaining the benefit of a largely tax-exempt investment account until that date when the surcharge tax will become due on the excess value of the fund – 55% if taken as a lump sum or 25% tax if taken as income.

    If you have no need for the funds in excess of the LTA then you could consider leaving these invested in your pension. Although you have to pay the LTA charge of 25% at age 75, the funds will remain outside of your estate. If you die after your 75th birthday your ultimate beneficiaries will have to pay income tax on the benefits but this may be preferable to you paying income tax on the income and inheritance tax (currently 40%) on any funds that remain in your estate. 

    Does this apply to me?

    You can work out whether you are likely to be affected by the Lifetime Allowance by adding up the expected value of your pension payouts:

    If you have multiple pension pots the value of all of your pensions will be taken into account.

    With a defined contribution pension, you won’t pay the lifetime allowance until you go over the lifetime allowance threshold or turn 75 (whichever occurs first).

    How much before I pay Lifetime Allowance?

    For defined benefit pension schemes, the lifetime allowance is usually calculated by multiplying your expected annual pension by 20. 

    You’ll also need to add the amount of any tax-free cash lump sum if it is additional to the pension. In many schemes, you would only get a lump sum by giving up some pension, in which case the value of the full pension captures the full value of your payouts. 

    So you are likely to be affected by the lifetime allowance in 2020-21 if you are on track for a final salary pension (with no separate lump sum) of more than £53,925 a year.

    Note that certain tax-free lump sum benefits paid out to your survivors if you die before age 75 also use up lifetime allowance.

    Source: Money Advice Service 

    When paying more into your pension might not make sense

    From April 2016 income tax relief on pension contributions has being tapered from £40,000 per year for anyone with total earnings of less than £150,000 down to £10,000 per year for those with earnings over £210,000.

    If you are over your LTA this could mean you will pay 45% tax on your deemed contribution to a scheme which will generate no further tax-free cash and only pension income taxed at 55% or more.

    Some employers are now offering salary enhancements to members who opt out of defined benefits schemes who will be caught by these changes. Check with your pension administrators if this applies to you.

    Pensions and Inheritance Tax

    It’s worth remembering that Pensions are a legitimate way of passing on wealth free of inheritance tax.

    When you die, if the value of your estate exceeds the Inheritance tax threshold then your beneficiaries will be liable for 40% inheritance tax. However, money held within your pension is exempt from this charge, so you may wish to consider this when planning how you will manage your money.

    What to do if you’re over the Lifetime Allowance 

    If you do find yourself over your Lifetime Allowance, or you think you’re going to be, it is worth speaking to your financial advisor to discuss alternative tax-efficient savings. If you accrued your Pension before April 2016, depending on your circumstances, you may be able to apply for protection against the changes up to £1.25 million. See the government website for details. 

    Final Salary Pension Guide

    If you’re considering a Final Salary Pension Transfer it is always worth seeking financial advice from a qualified Pension Transfer Specialist. If you don’t know where to start our Definitive Guide to Final Salary Pension Transfer should point you in the right direction.

    definitive guide to defined benefit pension transfer

    Simon Garber is an Independent Financial Adviser and Pension Transfer Specialist with over 15 years of experience. He's a member of the Personal Finance Society and holds the coveted Gold Standard for Pension Transfer Advice.

    He is the Managing Director of 2020 Financial Ltd, Financial Advisors specialising in Retirement Planning & Wealth Management, based in Southampton, Hampshire.

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