Don’t be caught out by the lower lifetime savings allowance.
New rules on the total amount of money that can be saved tax-free in a pension are set to come into force in April 2016. The lifetime allowance was £1.8m in 2011-12, but George Osborne reduced this to £1.25m in 2014, and the limit will now be lowered further, to £1m.
Pension savings in excess of £1m will be taxed at 55 per cent when the pension pot is accessed. Labour had already announced its intention to do this, so it seems the change will take place regardless of the outcome of the General Election.
TAX ON SUCCESS
The lifetime allowance has proved controversial since it was first introduced in 1996, not least because the limit imposed has been greatly reduced in recent years. Now, at the lower level of £1m, financial advisers are concerned at the numbers of people likely to be affected.
Although £1m sounds like a lot of money, those who save diligently throughout their working lives and achieve good returns from their investments could reach the limit. For those paying in to a defined contribution pension, such as a Sipp, the lifetime allowance means savers take on all the downside risk of their investments, but any upside is capped, since success could mean a 55 per cent tax.
According to HMRC, the £1.25m limit affected 360,000 pension savers. Cutting the limit further will likely bring tens of thousands more up to the threshold.
Moreover, savings of £1m will not necessarily make for a millionaire lifestyle in retirement.
“The further reduction to the lifetime allowance sets a ceiling for a tax-approved pension income of just £26,750, based on today’s annuity rates,” explains Tom McPhail, head of pension research at Hargreaves Lansdown.
In a further complication, Osborne announced the lifetime limit will begin to rise in line with inflation from 2018. This means the limit will be higher, but the uncertainty has not been welcomed. “We need to have a period of stability where we know the limit is there and is not going to change,” says Adrian Walker, head of pensions at Old Mutual Wealth.
REACHING THE LIMIT
At the moment, a clause in the new rule could allow those who are nearing the limit to avoid the tax.
“If your pension is already worth more than £1m or you think it will be by the time you retire, then you will be allowed to apply to keep the higher limit of £1.25m that applies now,” explains Alan Higham, retirement director at Fidelity Worldwide Investment.
The government will outline more details on what this will entail before April 2016, but one thing is certain; you will not be allowed to pay more in to your pension if you keep the higher limit. This is a scary thought considering how low annuity rates are currently.
Old Mutual’s Walker says the first step in navigating the lifetime allowance is to work out exactly how much you have saved. For defined contribution savers, the pot is valued as simply the total sum of money in all of the individual’s pensions accounts.
It is a little more complicated for defined benefit pensions. Here, you ascertain the likely level of annual pension income you will receive and multiply this by 20. Then add on any lump sum you expect to take for the final valuation of your pension pot.
The next stage should be a conversation with a financial adviser, Fidelity’s Higham says. “You should take action now. A possible starting point is an initial conversation with a retirement expert to identify what tax you might be exposed to.”
McPhail says it is “essential that investors take full advantage of all the remaining tax breaks available to them”. This could mean building a portfolio of Isas to fund retirement. Walker explains: “You will be paying in to your Isa after tax, but the beauty is whatever size it grows to, you can take it all tax free.”
However, there are two main limitations: “First of all there is an annual cap on how much you can put in an Isa, which is £15,000 at the moment. An employer cannot put anything in either,” he says.
Some employers may begin to offer their pension contributions as a salary top-up instead. Lumping workplace pension contributions together with wages means they will only be subject to the individual’s income tax rate, which is 45 per cent at the highest rate.
National insurance will also be payable, but this upfront taxation could help avoid uncertainty over the future 55 per cent tax if the lifetime allowance is breached. If this option becomes available, those with larger pensions should seriously consider it, Walker says.