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Did you know there is a limit to how much you can save into a pension? It is called the lifetime allowance, and in 2020-21 it is set at £1,073,100. This may sound like an unattainable goal for many readers (especially those on lower salaries starting in their careers), yet it is not unheard of for individuals to inadvertently exceed this limit – without even realising. Should this happen, the saver can face a huge tax charge at 55% if any amount is taken as a lump sum, or 25% if you take anything as an income.
Here at Elmfield Financial Planning in Padiham, Burnley, Lancashire our goal is to help people achieve the best retirement possible. This, naturally, involves helping our clients navigate the complex, changing landscape of UK pension rules. In this short guide, we outline some of the key things you need to know about the lifetime allowance.
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Overview to the lifetime allowance
Some may ask why the UK has a cap on how much you can save into a pension. The reason, given by some defenders, is that it helps ease the burden on the state. After all, the UK government foregoes tax on your pension contributions and, instead, puts the money it would have collected into your pension (tax relief). So, for a basic rate taxpayer in 2020-21, this means it “costs” you 80p to put £1 into your pension – since the government provides 20% tax relief. For a higher rate taxpayer, this system is even more beneficial, costing you 60p to put in £1 (40% tax relief).
Nonetheless, the lifetime allowance is a lot of money (£1,073,100). How is it possible to go over it? There are many reasons why this can happen. First of all, compound interest can work for or against you as a pension saver. It can provide enormous growth to a portfolio over 20, 30 or 40 years (which is why it is important to start saving early for retirement). On the other hand, this growth can spiral out of control within a pension without careful planning, leading to someone breaking the threshold of the lifetime allowance.
Secondly, some jobs provide such generous pension benefits that they have been known to inadvertently exceed the lifetime allowance. In early 2020, for instance, you may recall that certain NHS doctors were retiring early or refusing to take extra shifts. This was because the complex annual allowance rules, at the time, were leading to unexpected pension tax charges for senior doctors. Indeed, the issue is still not fully resolved despite the Chancellor’s reforms in the March 2020 budget – with the BMA arguing that these are an “an unfair tax on doctors”.
Navigating the lifetime allowance
How can you tell if these issues surrounding the lifetime allowance apply to you? The first step, for workers, will be to work out the value of your pension(s). For instance, suppose you are 55 years old and have four pension pots currently containing £800,000. Here, you have £273,100 left in your lifetime allowance before you exceed your limit. This could happen if you continue putting large contributions into your pension over the next 13 years (when you hope to retire). As such, it is likely that this person needs financial advice to consider their options. One idea might include lowering the pension contributions and, instead, diverting these into an ISA (where you can commit up to £20,000 per tax year and generate tax-free capital gains, interest and dividends).
Calculating the value of your pensions is easier with defined contribution pensions – i.e. those which have a “pot” of money which you (and possibly your employer) have built up over time. For those with a defined benefit or “final salary” pension, however, things can be more complex. This is because there is no “pot”, as such, but rather your employer promises you an annual income when you retire. Here, a good starting point to work out the pension value is to multiply your anticipated income from the scheme by 20. For example, if you expect to receive £6,000 from a final salary pension when you retire, the value of the scheme may be close to £120,000.
There are certain cases where it is possible to “go over” the lifetime allowance, via the Individual Protection 2016 (IP2016) rules. Here, you will need to meet certain criteria to be eligible to apply – i.e. your pension savings on 5th April 2016 were over £1m. These exemptions are complex to figure out, and so it is often worthwhile turning to professional help to leave no stone unturned.
If you are interested in starting a conversation about your own financial plan or investments, then we’d love to hear from you. Please contact us to arrange a free, no-commitment consultation with a member of our team here at Elmfield Financial Planning in Padiham, Burnley, Lancashire.
Reach us via:
T: 01282 772938