Introduction & Background
The concept of a Lifetime Allowance for pensions came into effect on 6th April 2006 (A-Day), when a raft of ‘pension simplifications’ were introduced. In exchange for reducing the complexity of pension rules in existence until this point, the Lifetime Allowance ensures that when an individual brings pension benefits into payment that exceed the prevailing allowance, a tax charge of 25% or 55% will apply to the excess.
When it was introduced in 2006, the Lifetime Allowance was £1.5m, but it rapidly increased in successive years until it reached £1.8m in the 2010/11 tax year. While it remained at this level the following tax year, it reduced to £1.5 in 2012/13, £1.25m in 2014/15 and down to £1m in the 2016/17 tax year. There was a commitment from the Government for the Lifetime Allowance to increase in line with the Consumer Prices Index each year from 2018/19 onwards, in the wake of the Covid pandemic the Budget this year suspended these increases until the 2026/27 tax year at the earliest. The Lifetime Allowance currently therefore stands at £1,073,100.
Impact of the Lifetime Allowance
Each time an individual accesses their pension funds in some way (or when they reach age 75 or upon death beforehand), this is deemed a ‘Benefit Crystallisation Event’.
For money purchase pension arrangements, it is a fairly straightforward calculation to determine what proportion of an individual’s Lifetime Allowance is utilised by accessing pension benefits.
|Example 1. Money purchase crystallisation to access Pension Commencement Lump Sum
John age 55 decides to ‘crystallise’ part of his £800,000 pension pot to access £40,000 of his tax-free Pension Commencement Lump Sum (PCLS) entitlement.
Although John’s pension funds currently equate to 74.55% of the Lifetime Allowance, as he is only crystallising £160,000 of his overall pot in order to access 25% of this total as a PCLS, he is only using 14.91% of his Lifetime Allowance on this occasion (i.e. £160,000 divided by £1,073,100 x 100).
With defined benefit pensions however, it is not quite as simple a calculation as illustrated by the following example:
|Example 2. Defined benefit pension being brought into payment
Anna reaches the normal retirement age for her ‘final salary’ pension at age 65 and will receive a pension of £45,000 per annum together with a lump sum of £135,000.
All of Anna’s pension entitlement is coming into payment at the same time and the Benefit Crystallisation Event (BCE) calculation for Lifetime Allowance purposes is as follows:
BCE = Pension x 20, plus pension lump sum (i.e. (£45,000 x 20) plus £135,000 = £1,035,000)
As a result, Anna’s pension benefits will use up 96.45% of her Lifetime Allowance (i.e. £1,035,000 divided by £1,073,100 x 100).
Types of Protection
When the Lifetime Allowance (LTA) was introduced back in 2006, in a bid to help individuals that had built up pension funds worth in excess of the new £1.5m Allowance, two forms of LTA protection were introduced:
- Primary protection: this form of protection was available to individuals with total benefits worth greater than £1.5m as at 5th April 2006. The amount above £1.5m gave them an enhancement factor to apply to the standard LTA for crystallisation events after 5th April 2006.
- Enhanced protection: anyone could apply for this form of protection regardless of the value of their pension benefits and it gave them exemption from the LTA tax charge. However, in exchange for this valuable protection, the member could have no further ‘relevant benefit accrual’.
While this simply meant no further contributions as far as a money purchase pension is concerned, ongoing accrual could continue (to some extent) within defined benefit schemes. There is however a limit on what can be paid out (or transferred to a money purchase pension scheme), based upon the revalued benefits accrued at A-Day.
These ‘A-Day’ protections had to be applied for by 5th April 2009.
Protections from decreases in the Lifetime Allowance
Each time the LTA has dropped (from a high of £1.8m), HMRC introduced protections to allow people to retain a higher personalised LTA. The protections available were as follows:
- Fixed protection 2012 (FP2012): allowed individuals to retain a £1.8m LTA provided there is no relevant benefit accrual from 6th April 2012 onwards. This meant no contributions to money purchase schemes and increases to defined benefit schemes must be less than the increase to CPI or the rate specified in the scheme rules on 9th December 2010. Had to be applied for before 6th April 2012.
- Fixed protection 2014 (FP2014): works in the same way as FP2012, but with the LTA retained at £1.5m. Increases to defined benefit schemes were again limited to CPI or on this occasion the rate specified in the scheme rules on 11 December 2012. Had to be applied for before 6th April 2014.
- Individual protection 2014 (IP2014): could be applied for where the member’s benefits were worth at least £1.25m and the LTA would be protected at that level (subject to a maximum of £1.5m). Making further contributions to a money purchase arrangement or future benefit accrual within a defined benefit scheme does not invalidate this form of protection. Had to be applied for by 5th April 2017 (based upon the individual’s benefits at 5th April 2014).
- Fixed protection 2016 (FP2016): works in the same way as previous versions, but with the LTA retained at £1.25m. Increases to defined benefit schemes were again limited to CPI or on this occasion the rate specified in the scheme rules on 9 December 2015. There is however no deadline to apply for this protection - as long as there has been no relevant benefit accrual since 6th April 2016 it is still possible to apply for FP2016.
- Individual protection 2016 (IP2016): could be applied for where the member’s benefits were worth at least £1m, the LTA would be protected at that level (subject to a maximum of £1.25m). Making further contributions to a money purchase arrangement or future benefit accrual within a defined benefit scheme does not invalidate this form of protection. Similar to FP2016, there is no deadline to apply for this protection, as long as the individual had benefits greater than £1m as at 5th April 2016.
Protection in action
Where an individual benefits from primary protection, their enhancement factor is applied to the standard LTA (guaranteed not to drop below £1.8m – the highest rate the standard LTA rose to).
|Example 3. An individual with primary protection dies before age 75.
Carol (aged 60) whose pension funds were worth £1.95m at A-Day has primary protection with an enhancement factor of 0.30, which means that the ‘standard’ LTA is enhanced by 30% on benefit crystallisations.
Carol hasn’t crystallised any benefits before and her pension funds are worth £3m when she sadly dies. Carol’s protected Lifetime Allowance is therefore £1.8m x 1.30 = £2.34m. A Lifetime Allowance tax charge will therefore apply to the £660,000 balance above Carol’s protected LTA.
This is without doubt the best level of protection available. Although the member has not been able to accrue any further benefits since 5th April 2006, whatever value their pension funds and/or defined benefit pensions grow to, they will never suffer a Lifetime Allowance tax charge.
Fixed protection is pretty straightforward in that the protected level of their LTA is the figure that is used when benefits are crystallised.
|Example 4. A member of a final salary scheme with fixed protection 2012 is due to retire.
James (aged 65) reaches the normal retirement age of his employer’s Career Average Revalued Earnings defined benefit pension scheme and is due to receive a pension of £80,000 per annum together with a retirement lump sum of £240,000.
If James take benefits on this basis, although he has a protected LTA of £1.8m, he will still suffer a Lifetime Allowance tax charge.
His pension of £80,000 is valued at £1.6m for LTA purposes (i.e. £80,000 x 20) and when the lump sum of £240,000 is added, £40,000 will be subject to a Lifetime Allowance tax charge.
However, as James is able to commute part of his pension for additional lump sum (on a commutation rate of 1:12), he could increase his lump sum to a maximum of £450,000 (i.e. £1.8m x 25%)
However, with advice, James opts to commute £5,000 of his pension for an additional £60,000 of retirement lump sum together with a pension of £75,000 per annum.
The revised LTA calculation on these benefits results in exactly 100% of James’ protected LTA being used by this crystallisation (i.e. £75,000 x 20 = £1,500,000 plus the £300,000 retirement lump sum).
The Lifetime Allowance tax charge
The tax charge is 55% of funds in excess of the applicable LTA if the balance above is taken as a lump sum and is deducted from the lump sum. However, where the excess remains within the pension (or where it is paid out as a taxable income), the tax charge on the excess is 25% and can be paid by the pension scheme or the member (or a combination of the two).
Opting not to apply for protection
An individual with funds approaching or above the current Lifetime Allowance that has not contributed to pension (or increased accrual within a defined benefit scheme) since 5th April 2016 could still apply for fixed protection 2016 (FP2016) and benefit from a protected Lifetime Allowance of £1.25m. However, pension contributions attract income tax relief of up to 45% (46% in Scotland), and where contributions are made to reinstate an individual’s personal allowance, the effective rate of tax relief is 60%.
When you combine this with the fact that the member’s employer may also be willing to contribute to the member’s pension, a viable option could be to forego protection on the understanding that the eventual tax rate on the excess funds over the member’s Lifetime Allowance will be 25%, AND the pension funds will (in the vast majority of cases) be exempt from Inheritance Tax on the member’s death.
Payment of the Lifetime Allowance tax charge
Following on from the last point, while a member can retain the balance over the Lifetime Allowance within the pension fund and instruct the pension provider to pay the tax charge, bearing in mind that the fund will likely be exempt from inheritance tax, the member could opt to pay the tax charge out of assets that do form part of their estate (subject to affordability).
The Lifetime Allowance and the protections available can be a particularly complicated area of an individual’s retirement planning. As a result, this is a highly specialist area of financial planning where the services of a qualified financial planner can significantly improve a client’s outcome.
Please contact your local Smith & Williamson Financial Planner if you would like to discuss your circumstances on a no obligation basis.
This article is of a general nature and is not a substitute for professional advice. No responsibility can be accepted for the consequences of any action taken or refrained from as a result of what is said.
Rates of tax are those prevailing at the time, are subject to change without notice and depend on individual circumstances. Clients should always seek appropriate tax advice from their financial adviser. Source Gov.uk 2021/2
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
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