How to deal with pension pot limits
If your retirement fund is worth over £1m there may be a nasty shock ahead in the form of a 55pc tax, writes Sam Meadows
GPs, surgeons and head teachers are among the fortunate professionals to enjoy gold-plated “final salary” pensions. But many will be unaware of trouble brewing with these valuable entitlements – trouble that could see their retirement income eroded by punitive taxes.
This is because of a £1m statutory limit on the value of a pension fund before tax-free status is lost. This “lifetime allowance” applies to final salary schemes as well as other types, even though there is no separate pot of money with your name on it. The rules stipulate that a starting pension of £50,000 a year from a final salary scheme is worth £1m.
Long-serving employees at middle-ranking and senior levels could easily be on course for a £50,000 annual pension and therefore face being caught by the tax, which is charged at 55pc on any excess over the £1m cap.
It is of course also possible to accumulate £1m in non-final-salary (“defined contribution”) pensions, or in a combination of the two. With a defined contribution pension, however, you are more likely to be aware of its value.
Either way, anyone who has more than £1m in pensions faces a highly complex tax regime, so understanding the lifetime allowance and minimising its impact are extremely difficult. Some workers are so afraid of breaching the £1m limit, they retire early to prevent their pension from growing further. But this extreme course of action may not be necessary.
The following guide will help workers in this situation find the best possible outcome.
What is the pensions lifetime allowance and where did it come from?
The lifetime allowance is the total amount you are able to build up in your pension without incurring an additional tax charge. The basic principle is the same whether you are in a defined benefit, or “final salary”, pension or a defined contribution scheme. The latter is a distinct pot of money with a clear value, while in the former case the value is calculated as 20 times your initial annual pension.
The allowance was introduced in 2006 at a level of £1.5m and initially rose each year until it reached £1.8m in 2010. But a series of cuts then followed: first to £1.5m in 2012, then in 2014 and 2016 to £1.25m and £1m respectively.
Each time the limit changed, those affected had an opportunity to apply for special dispensation, called “fixed protection”, to keep the lifetime allowance at the level prevailing before the cut, although they had to cease to be an active member of a pension scheme. In 2014 and 2016 it was also possible to get “individual protection” which meant that your lifetime allowance would be fixed at the previous level or at the value of your pot at the time if this was lower.
It is still possible to apply for the 2016 version of both fixed and individual protection. To be eligible you must not have been a member of a pension scheme, or made contributions to one, since April last year.
What happens if I have exceeded my lifetime allowance?
The short answer is that you will get taxed – and heavily so. But you will still have access to a portion of the value of your pot above the limit, so it can be argued that it’s better to have the money and be taxed than not have it in the first place.
How much you pay depends on how you draw on the money. Defined contribution pensions can be taken as a lump sum or as income. If you take a lump sum, the amount above the allowance will be taxed at 55pc. If you take your pension as an annual income you are taxed at 25pc – on top of the normal income tax payable.
Most pensioners whose pot exceeds the lifetime allowance are likely to be higher-rate taxpayers, but these people would not end up paying more tax than those who take a lump sum, despite them appearing to pay 25pc and then 40pc. This is because the latter rate applies to a smaller sum than was subject to the initial 25pc rate. In pounds and pence, you pay the same tax either way.
If you are a basic-rate taxpayer and exceed the lifetime allowance, taking some of your pot as income could be a cost-efficient way to limit the charge. Your liability to tax will not be calculated when you hit the limit but only at key points: the most common are when you start to take an income, when you turn 75, or on death.
For final salary schemes there are further complications. Alistair Cunningham, financial planner at Wingate Financial Planning, said the scheme itself must pay the tax upfront as a one-off payment. It will then recoup the cost from you by reducing the annual amount you draw from your pension. He said this, confusingly,
‘My view will always be that tax is only bad if the net benefit isn’t worth it’
could mean that you may pay more over the course of your retirement than you actually owe. Of course, it can also mean you pay less. The way the reduction is calculated differs between schemes and according to your age.
What can I do?
In most cases, it is likely to be better for you to just take the hit. Even if you get taxed at 55pc on the excess, 45pc of something is clearly better than 100pc of nothing at all.
Mr Cunningham said two extra years in a generous final salary scheme could make a big difference to your pension income in retirement – despite the extra tax.
Les Cameron of Prudential, the insurer, said: “My view will always be that tax is only bad if the net benefit isn’t worth it. Nobody gives up a pay rise because they will pay more income tax. It can still be a good deal.”
If you are in a scheme where you are not contributing, the additional benefit won’t be costing you anything and to leave the scheme early to save tax would be illogical. If you are making contributions there are a few ways to mitigate your entitlement. Mr Cameron said you could simply stop making contributions before you reach the lifetime allowance. This requires you to be aware of the exact value of the pot, but could mean you make an overall saving. He said: “If it’s only your contributions going in, the tax relief going in probably isn’t worth the tax hit coming out.”
Another option is to give up some of your pension. In most defined benefit schemes you can give up some pension income in exchange for a tax-free lump sum, although there can be technical restrictions at some schemes. Mr Cameron said this would certainly limit your tax liability, but the reduced income could mean you would not end up better off in the long run.
You could also take a lump sum early if you are approaching the limit.
If, say, your pension was worth £1m and you took your maximum £250,000 sum, the remaining pension would be worth £750,000 – well below the allowance. Although the pot will continue to grow, if you begin to take income from it when you retire it is unlikely to top £1m when you turn 75 or die.
“At the margins this could be the difference between being over the lifetime allowance or not,” he said.
He added: “There are many things where a do-it-yourself approach will work, but because of the sums involved it’s worth paying for advice on this occasion.”