The Pension Lifetime Allowance is the maximum pension pot you can build before an additional tax charge will apply on lump sum withdrawals or income drawdowns.
The Pension Lifetime Allowance must be an important consideration for any pension saver in the UK who believes that they are likely to reach this level by retirement. Why? Because significant tax charges apply where this limit is exceeded.
How big is the Pension Lifetime Allowance?
The Pension Lifetime Allowance peaked in 2010-11 at £1.8m but has gradually been reduced by successive governments in a bid to increase tax receipts for the treasury.
In the 2021 Budget speech, the Chancellor announced that the Pension Lifetime Allowance would be held at £1,073,100 until April 2026.
As a result of these changes, many people who perhaps were not expecting to be caught by these charges, now will be.
What counts towards the Pension Lifetime Allowance?
The Pension Lifetime Allowance limit applies to all pension pots held.
Different rules are applied depending on whether you have a defined contribution or defined benefit pension scheme:
- Defined contribution – The value of all holdings in your defined contribution pension schemes, regardless of how you decide to take the money.
- Defined benefit – Typically 20x first year pension income plus your lump sum.
When does a tax charge apply?
When a ‘benefit crystallisation event’ happens, a test against the Pension Lifetime Allowance is performed.
There are several crystallisation events (see HMRC guidance for full details), but the most common include withdrawing money from your pension, reaching age 75, transferring to an overseas pension scheme or passing away.
At age 75, if a crystallisation event has already taken place, a second crystallisation event takes place on any growth in the value of the drawdown funds (under rule BCE5a).
Tax charges applicable
The tax charges applicable on any excess above the Pension Lifetime Allowance are:
- 55% if you take out the cash as a lump sum, or;
- 25% if you receive the cash via income drawdown.
Calculating the Pension Lifetime Allowance
Each time a benefit crystallisation event happens, you calculate what % of the Pension Lifetime Allowance you have used up. This percentage is always calculated to 2 decimal points, rounded down (e.g. 88.566% would be rounded down to 88.56%).
The Pension Lifetime Allowance used for the calculation is the limit applicable at the point of each benefit crystallisation event.
To illustrate these points, let’s consider an example:
Steve, who was 66 in 2012 has a SIPP valued at £1.3m.
In 2012, when the Pension Lifetime Allowance was £1.5m, Steve decided to take 25% (£325k) of his £1.3m pension pot as a tax-free lump sum. The remaining 75% (£975k) was placed into drawdown, but he decided to let this pot grow rather than withdrawing funds.
At this point, Steve has used up £1.3m (86.66%) of his Pension Lifetime Allowance (calculated as £1.3m divided by £1.5m), leaving him with 13.34% of his allowance remaining.
In 2021, Steve turns 75. At this point, a second crystallisation event takes place, but is only calculated in relation to the growth in the remaining pension pot. His £975k drawdown pot has now grown to £1.7m (6.37% compound annual growth rate across 9 years).
As this is another crystallisation event, we look at this growth (£725k) against the value of the current Pension Lifetime Allowance. The limit in 2020/21 has reduced to £1,073,100 so the £725k now represents 67.56%. However, as we know, Steve has only 13.34% of allowance remaining.
This means £143,151 (13.34% * £1,073,100) will be covered under the Lifetime Allowance, but the remaining balance of £581,849 will be subject to a Lifetime Allowance tax charge.
As Steve does not intend to take the pension as a lump sum, the lifetime allowance charge applicable is £145,462 (25% * £581,849). The total size of the pension pot would therefore reduce from £1.7m to £1,554,538 (£1.7m less £145,462).
What Pension Lifetime Allowance rules are applicable on death?
The rules applicable on death depend upon your age at the point of death.
If you die before age 75:
- A Pension Lifetime Allowance test will be performed on any uncrystallised funds.
- The recipient of your funds will not need to pay income tax on funds received, provided funds are designated within two years of death.
- If funds are not designated within two years of death, there will be no benefit crystallisation event, but the recipient will have to pay income tax on any receipt of funds.
If you die after age 75:
- No further Pension Lifetime Allowance test will be performed.
- However, the recipient of your funds will be required to pay income tax on funds received.
Does it make sense to continue pension contributions if you will breach the Pension Lifetime Allowance?
Unfortunately, this question cannot be answered generally as it entirely depends upon your personal circumstances.
However, a few of the things you should consider are:
- The level of tax relief you receive on pension contributions.
- The fact that investments held in your pension pots benefit from compound tax-free growth until the point at which benefits are taken.
- Employer pension contributions – do you have an option to ask your employer to stop paying pension contributions and pay you directly or with other benefit instead?
- What other alternative tax efficient investment options do you have available (e.g. ISAs, VCTs).
- What are your future plans for your pension funds?
If in doubt, we would highly recommend speaking to an independent financial advisor, who will be able to tailor their advice to your specific circumstances.