Will your pensions get caught in the lifetime allowance trap?

Pension written on a calculator

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If you have several UK pensions, have been saving for many years or have a generous company pension, you could be at greater risk of 25% or 55% tax penalties following recent measures.

One key outcome of the 2021 UK Budget was that the pensions lifetime allowance (LTA) was frozen at its current level for at least the next five years. This measure alone is estimated to net the Treasury approximately £990 million by 2026, pushing an extra 10,000 people over the threshold.

With LTA tax penalties as high as 55%, make sure you are not caught unprepared.

What is the lifetime allowance?

Since 2006, the UK government has capped how much you can hold in combined pension benefits without paying extra tax. Originally £1.5 million, the LTA peaked in 2011 at £1.8 million before gradually dropping to £1 million in 2016. Tracking inflation since then, the March 2021 Budget cancelled this year’s scheduled increase, freezing the LTA at its current level of £1,073,100 until at least 2026.

Who is affected by the lifetime allowance?

While the current lifetime allowance of £1,073,100 sounds high, it does not just capture the ultra-wealthy.

All UK pension benefits outside the State Pension are counted, including everything accumulated over a working lifetime. After decades of pension contributions, compounding interest, investment growth and tax relief, the limit may be closer than you think.

For ‘final salary’ (defined benefit) pension schemes, the usual measure of value is 20x the annual income due. Generally this will mean those with pensions worth £53,655+ a year would be affected today.

What are the lifetime allowance penalties?

Once total pension funds exceed the allowance limit, extra tax is payable whenever you access your money – technically called a ‘benefit crystallisation event’. How much you pay depends on the way funds are withdrawn – the rates are:

  • 55% for lump sums;
  • 25% for income or transfers to an overseas pension.

So at best, the cost of being over the LTA can be a quarter of your funds, at worst: over half.

Being non-UK resident offers no protection. Usually, under the double tax agreement, residents of countries like Portugal, Spain, France and Cyprus are not liable for UK taxes on British pensions (except government service pensions). However, for anyone over the allowance, these rules do not apply – the LTA tax is applied in the UK first and cannot be claimed back.

How can you check your LTA position?

Calculating how much of your allowance you have used is not always straightforward, especially for final salary pensions, so you should check your position with your provider or pension adviser.

HM Revenue & Customs (HMRC) will first test your allowance status when you start drawing your pension, then every time you access funds and when you turn 75. If you die before age 75, any lump sums paid to your beneficiaries will also be subject to the LTA test and subsequent tax penalties.

How can you protect your pensions from the lifetime allowance?

You could secure a higher limit by applying for LTA ‘protection’ from HMRC, but this usually has strict conditions attached, so take guidance first.

Expatriates have the option of transferring UK pension funds to a Qualifying Recognised Overseas Pension Scheme (QROPS).

If you transfer one or more UK pensions into a QROPS and your total benefits are under £1.073 million, you will not face LTA taxes on the transfer. However, make sure the QROPS is within the European Economic Area (EEA), otherwise you would still lose 25% through the ‘overseas transfer charge’.

Once in a QROPS, funds are out of reach of LTA penalties, no matter how much you have or how you access it. A suitable QROPS can also provide tax-efficiency, currency flexibility and estate planning benefits.

See more on the pros and cons of transferring to a QROPS

An alternative option is to explore taking your UK pension as cash and reinvesting it into a tax-efficient, compliant arrangement in your country of residence. Again, this can unlock other benefits not usually available with UK pensions.

Reviewing your pension options

Before making any major pension decisions, it is crucial to take regulated, personalised advice to avoid pension scams and determine your most suitable approach.

But what if you are already over the limit? While you would trigger an immediate 25% LTA charge if you transferred to a QROPS, the funds become immune to further penalties. If you instead transferred to a UK scheme, like a Self-Invested Personal Pension (SIPP), you would not trigger immediate taxation but the funds would remain liable – with future charges increasing as funds grew. The 25% or 55% LTA penalties would then become payable whenever you take benefits and also apply to any heirs inheriting the pension.

If you are over or close to the LTA threshold, consider acting sooner rather than later. Your pension funds should continue to grow while the lifetime allowance remains frozen, so you could potentially avoid unnecessary taxation by taking steps now.

Even if your pension benefits are within the allowance or you are not yet ready to access them, it is a good idea to review your situation. If you are living in Spain, France, Portugal, Cyprus or Malta, Blevins Franks can help you explore your options and take advantage of tax-efficient opportunities to secure a comfortable retirement.

Contact us to discuss your pension options

Tax rates, scope and reliefs may change. Any statements concerning taxation are based upon our understanding of current taxation laws and practices which are subject to change. Tax information has been summarised; individuals should seek personalised advice.