Saving for retirement is a key part of financial planning, but the Lifetime Allowance is impacting more people when they start to take their retirement benefits.
What is the Lifetime Allowance?
The Lifetime Allowance is set by the Government and is a cap on the total value of your pension benefits. This allowance was first introduced in 2006 at £1.5 million, but has since been reduced to its current level of £1.055 million in 2019/20. The current plans are that the Lifetime Allowance will increase by Consumer Prices Index (CPI) each year. As a result of the lower allowance, more people are facing this problem.
What happens if you exceed the Lifetime Allowance?
As pensions are normally a long term commitment, what might appear modest today could exceed the Lifetime Allowance by the time you want to take your benefits. Your pension benefits will be tested against the Lifetime Allowance when you start to take your benefits, at age 75 or on your death. If the value of all your pension benefits exceeds the Lifetime Allowance, tax is only applied on the value of your benefits in excess of the Lifetime Allowance.
For a client with total pension funds valued at £1.155 million, against the current lifetime allowance of £1.055 million, if all funds are taken as retirement benefits:
Tax free lump sum of £263,750 can be taken, being 25% of the lifetime allowance.
The remaining fund within the lifetime allowance (£791,250) is used to provide pension income.
The fund in excess of the Lifetime Allowance of £100,000 can be either:
1) paid as a lump sum subject to 55% tax – therefore a net lump sum (in addition to tax free lump sum above) of £45,000
2) taxed at 25% with the net amount of £75,000 added to £791,250 to give a total remaining fund of £866,250 to provide pension income. Any future investment growth on this fund will be subject to a further 25% Lifetime Allowance charge at age 75 or on earlier annuity purchase.
How to manage your retirement income
If you only access part of your pension fund before age 75, then you only need to pay a Lifetime Allowance charge if the value of the benefits which you access exceeds the Lifetime Allowance.
You could choose to access funds below the Lifetime Allowance without triggering a charge. You will be able to access tax free cash of 25% of the pension fund and take taxable income to the required levels, ideally keeping within the basic rate tax band to avoid losing income to higher rate tax.
Your remaining fund may grow further which may mean that you may be liable to the Lifetime Allowance charge at age 75 (the latest point for a Lifetime Allowance assessment) or when you take your remaining benefits earlier or if you die before age 75.
Taking benefits from only some of your pension fund, up to the Lifetime Allowance, means that you avoid triggering the tax charge. You will also benefit from yearly increases in the Lifetime Allowance until your total pension fund is subject to the assessment or you can use make gifts to reduce any additional tax charge or gift income to reduce any potential Inheritance Tax liability.
What can you do to tackle the problem?
It can be very difficult to plan ahead, especially when the value of defined benefit pensions, based on salary and service, is generally linked to future increases in inflation and defined contribution pension funds, based on monetary value, grow in line with investment returns. Defined benefit pensions are valued as 20 times the pension at retirement plus the value of any tax free lump sum.
You may be eligible for a higher Lifetime Allowance up to a maximum of £1.25 million, using Fixed Protection or Individual Protection.
Fixed Protection allows you to have a Lifetime Allowance of £1.25 million, but only if you have not made any pension contributions or accrued any other pension benefits since 5th April 2016.
Individual Protection allows you to have a Lifetime Allowance equivalent to the value of your pension savings on 5th April 2016, where the value exceeded £1 million, up to a maximum of £1.25 million.
You can apply for these protections online on the Government website.
What are the alternatives?
If you are unsure whether your total pension benefits are likely to exceed the Lifetime Allowance, you should check the value of your pension funds. You can also consider alternative investments such as Individual Savings Accounts (ISAs), Venture Capital Trusts or Enterprise Investment Schemes.
The Lifetime Allowance has created an additional consideration for retirement planning if you have built up large retirement funds. Ask your Origen adviser who can provide advice and guidance on whether Lifetime Allowance will impact your pension savings and if so, we can provide recommendations on how to take your retirement benefits or recommend alternative actions to help you address this issue to best suit your financial needs.
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