In April next year the Lifetime Allowance applied to UK pensions will be reduced from ?1.8 million to ?1.5 million. If your total pension savings exceed or are likely to exceed this
In April next year the Lifetime Allowance applied to UK pensions will be reduced from ?1.8 million to ?1.5 million. If your total pension savings exceed or are likely to exceed this limit you need to take action now to protect yourself from unnecessary tax charges.
The Lifetime Allowance (LTA) is a limit on the value of retirement benefits (pension and/or lump sum) that you can draw from your pension schemes before tax penalties apply. When benefits come into payment for any reason, they are tested against the LTA and any excess will be subject to a tax charge.
Any amount over the LTA taken as a lump sum is taxed at 55%, while any amount taken as pension income is taxed at 25%.
The allowance was introduced in April 2006 when the figure was ?1.5m. It increased each year, reaching ?1.8m in April 2010. In October 2010 HM Revenue & Customs (HMRC) announced that it would be reduced right back to ?1.5 million with effect from 6th April 2012. The lower threshold may be in place for a while, resulting in more people having to pay the tax charge.
Many people think that the allowance test is only applied when they start taking benefits so they are safe from any further charges. Unfortunately this is not the case and even if you escaped the charge when you started drawing benefits, if your funds grow to above the LTA you could be hit by the tax charge in future ? and the new lower allowance makes this more likely.
The pension tax rules set out a number of situations where part of your LTA will be used up. Any event which results in the payment of a benefit is known as a Benefit Crystallisation Events (BCE) and will always be tested against the LTA at the time.
The BCE framework is designed to make sure that the LTA is applied to the total of an individual?s benefits across all registered pension schemes.
The first test against the LTA comes when you start drawing your pension. Your fund will be tested at the point of entering drawdown and taking your pension commencement lump sum. This will use up a percentage of your LTA and the remaining percentage will then be used for any later BCEs. The reduction in the allowance from ?1.8m to ?1.5m will also reduce the value of the remaining allowance.
Note that it is not a monetary figure ? if 100% of the LTA is used and the allowance subsequently increases, there will be no remaining entitlement.
You will always have a second lifetime allowance test. If you subsequently buy an annuity this is a BCE, and there will automatically be one when you reach age 75. The test will look at the growth of the fund since the last BCE and test it against the remaining unused percentage of your allowance.
If you die before age 75 any lump sums paid to your beneficiaries will be subject to the LTA test.
If you transfer your pension funds into a QROPS (Qualifying Recognised Overseas Pension Scheme) there will be a BCE and so another occasion to test against the prevailing LTA. If your allowance is exceeded there will be a tax charge, in this case of 25%.
However, once in a QROPS the funds are no longer liable for any further LTA charges. You may therefore be better off moving into QROPS and paying the charge now, since it will be capped and cannot grow any further, rather than deferring it and paying it later on.
If you are at or near the LTA there is always a chance that you may exceed your percentage of unused LTA in future. The risk increases when the allowance is reduced to ?1.5m.
The good news is that HMRC have agreed legislation for a new ?fixed protection? whereby you can fix your LTA at ?1.8m and so escape the reduction to ?1.5m ? something which could prove to be a valuable tax break.
To get fixed protection your fund does not actually have to be above ?1.5m, so you can consider applying for it if you think your pension savings may increase to above ?1.5m in future as a result of investment growth.
To protect your pension you need to take action sooner rather than later as all the paperwork must be completed and filed with HMRC by 5th April 2012.
Once you apply for fixed protection you cannot make any further contributions to registered pension schemes or accrue any more benefits. If there is no additional growth, then fixed protection has no detrimental effect. You will be able to change your mind in the future and can notify HMRC that fixed protection no longer applies and then make further contributions.
You can still take a pension commencement lump sum after applying for fixed protection ? HMRC will normally allow up to 25% of the crystallised value of the benefits to be paid as a tax free lump sum, so long as the lump sum does not exceed 25% of the individual’s available personal lifetime allowance.
The market volatility over the last few years have affected the underlying assets in pension funds, but should the markets start to improve this could push you closer to the lifetime allowance, which is something you need to bear in mind.
In today?s world, it is particularly important to protect your investment gains from taxation where possible. Contact a wealth management firm like Blevins Franks to discuss the options for your pension fund and how to make it as tax efficient as possible.
By David Franks, Chief Executive, Blevins Franks
8th November 2011
Statements relating to taxation are based upon current taxation laws and practices which may be subject to change.