More than 90,000 UK savers have stopped putting money into their pension since 2012 for fear of incurring tax charges, it emerged this weekend, following a Freedom of Information (FOI) request by former pensions minister Steve Webb, now director of policy at Royal London.
The pensions lifetime allowance (LTA) limits the amount any individual can hold in a pension without incurring punitive tax charges. When it was introduced in 2006, the LTA was £1.5m and rose every year to reach £1.8m in 2010. Since then, it has been cut successively to its current level – £1m for the 2016-17 tax year.
Webb’s request revealed that 90,000 people have applied for “fixed protection”, one of two kinds of protection which savers can obtain from HMRC. It exempts them from a potential tax charge of 55 per cent on any “excess benefits” above the £1m mark, but prevents them from putting any more money into their pension. In the last tax year, HMRC netted £126m in tax from savers who breached the LTA, either with their contributions or through growth in the value of their investments.
As the LTA has come down, pensions experts have called for it to be scrapped altogether. The news that so many savers are close to exceeding the LTA is worrying, not least because it lays bare the perverse framework, which has resulted from years of pensions tinkering by the Treasury and which appears now to be penalising both higher retirement saving and superior returns. Indeed, it also hits public sector workers with generous employer pension schemes.
While a £1m pension pot is beyond the dreams of most savers, low annuity rates mean it would buy a surprisingly small annuity and industry figures are concerned that the LTA is penalising those who are doing the right thing.
If your pension is at risk of growing over £1m, what are your options?
First, it is important to understand when your pot will be tested against the LTA. Known as “benefit crystallisation events”, these come when you begin to draw money from your pension after the age of 55, when you reach the age of 75, or when you die – whichever comes first.
“A lot of people get confused because they don’t know how to value their pension for LTA purposes,” says Gary Smith, associate director of financial planning at Tilney. For defined contribution (DC) pension holders, the LTA is measured against the total monetary value of your pensions. For defined benefit holders, it is 20 times the annual income you will receive, plus any additional tax-free cash lump sum.
Any excess over £1m will be taxed at different rates depending on how you take the money. If the excess is taken as a lump sum, the tax charge is 55 per cent, but it is only 25 per cent if taken as income, either as an annuity, through drawdown or scheme pension, plus your marginal rate of income tax.
Fixed and individual protection
Alongside fixed protection, savers who had already breached the £1m limit on 5 April this year can also apply for individual protection. These people won’t have to pay any excess charge on either 100 per cent of their current pension savings, or £1.25m – whichever is lower. The big advantage of individual protection is that you can continue to make contributions. Those who qualify can even apply for both types.
It’s still free money
It is important to remember that the LTA tax charge is only on savings over the £1m mark, not your whole pot. And if your employer pays into your pension directly, asking them to stop may not lead them to compensate you with a higher salary. “If, as part of your remuneration package, your employer pays 10 per cent of your salary into your pension, they may thank you for opting out of the scheme and may then not agree to increase your salary by 10 per cent,” says Smith.
In such cases, something is better than nothing. “If you have a pot of £1.1m, and decide to take the excess as income, the value of your pension would be £1,075,000,” says Smith. You would then pay personal income tax as you make withdrawals, so the extra £75,000 would help offset some of your future tax burden.
Members of DB schemes have things even better, Smith explains. For example, a DB holder in breach of the LTA by £100,000 would have the £25,000 tax charge divided by 20, with £1,250 deducted off their income each year. “It’s better to stay in the scheme, build up the bigger pension and incur the tax charge,” he says.
“A pot of such a size is serious money, so it is worth talking to an independent financial adviser,” says Webb. “Everybody’s circumstances are different. Tailored advice is a good idea.”