Are you caught by the pensions lifetime allowance cut?

April 2014 sees the pension lifetime allowance (LTA) cut from £1.5 Million to £1.25M. HMRC estimate that 30,000 people will be immediately affected by the cut and the consequences of breaking the limit are significant, a potential 55% tax charge on a part of your pension funds.

The lifetime allowance (LTA) is the maximum amount of pension saving you can build up benefitting from tax relief. If your pension savings exceed the LTA you'll suffer a tax charge on the excess… potentially at 55%!

From April 2014, the LTA will be lower than when it was introduced in 2006. It’s unlikely the allowance will change in the foreseeable future – it might even be cut again in the Budget – but even without a further cut it will continue to be eroded by inflation.

How can I work out if I am caught?

A £1.25M limit may not set alarms bells ringing. But with a frozen allowance those within sight of retirement don't have to be close to £1.25M now for it to be a problem. Investment growth can quickly accelerate the size of the pension pot.

This table shows the current pension pot that will grow to £1.25M over various terms to retirement based on different growth rates:

Years to go/growth 4% 6% 8%
3 £1,112,000 £1,050,000 £993,000
5 £1,028,000 £935,000 £851,000
10 £845,000 £698,000 £579,000

 

The above figures don’t include charges and growth is not guaranteed

In the above example, if your fund is worth £698,000 now with ten years to retirement then if on average your fund grew by more than 6% you would be potentially subject to a lifetime allowance charge

And this assumes contributions stop now.

It's even trickier where defined benefits (employer run pension schemes which pay you a pension based on rules set by the scheme) are concerned. Few people appreciate how valuable a DB pension is – or how it’s tested against the LTA.

Suppose you have a prospective pension of £25,000 a year from a previous job; this already eats up £500,000 of the allowance. Adding early leaver revaluation up to retirement, at say 3.3% over 10 years, takes the pension up to £34,590 per annum which would use up almost £692,000 of your LTA.

 

The following categories of pension holders are likely to be those most at risk:

  1. Pension pot already above £1.25M, with no protectionfrom the 2012 reduction. You should register for protection (see below). But which?
  2. Pension pot that may exceed £1.25M at retirement, even if pension saving stops now. As a minimum, you need to review your pension before April 2014. Protection should be considered.
  3. Pension pot that may exceed £1.25M at retirement as a result of continued pension saving. You need to review your pension saving regularly, even if you don’t opt for protection now.

 

OK, I’m at risk, what are the options?

The Government has introduced two new protection options to allow anyone caught by the reduction to lock into a higher LTA – 'fixed protection 2014' and 'individual protection'. The best option for you might be to elect for one, both, or even neither. There’s a summary of each type of protection in the table. The optimum course of action for you will depend on your individual circumstances.

Fixed protection 2014 Individual protection
LTA fixed at £1.5M Personal LTA based on benefit value at 5 April 2014 (or £1.5M if lower)
No 'benefit accrual' after 5 April 2014 Further contributions/DB accrual allowed
Must apply by 5 April 2014 Applications open to 5 April 2017
Can't have with primary, enhanced or fixed protection 2012 Can't have with primary protection. Consultation over holding alongside enhanced protection
Can have alongside individual protection Can have with fixed protection 2012 or 2014
   

What action should I be taking?

The LTA cut may present you with difficult decisions to make before 5 April. To protect or not? Which type of protection? Making the wrong choice could potentially expose up to £250,000 of your pension savings to a tax charge of up to 55%.

It could be costly if this issue is not addressed. No one wants to unexpectedly sleep-walk into a tax charge of up to £137,500.

Aside from the 'protect or not' dilemma, the potential cessation of, or cutting back on, pension saving after April 2014 raises other questions:

  • Should I pay a final pension top-up before the shutters come down in April?
  • Is reviewing my pension investments to de-risk them and mitigate the potential 55% tax charge worthwhile?
  • What about my legacy pensions?
  • Should I consider alternative (non-pension) tax wrappers for future savings?
  • What strategies should I employ for wealth decumulation?
  • What is the most efficient way to transfer wealth to the family?

The two new protection options to lock into a higher pension allowance and mitigate the forthcoming reduction, while welcome, complicate decision making – decisions you may not even realise are crucial to your future retirement planning strategy.

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