Beat the £1m lifetime allowance for pensions
Although the government wants us to save for retirement, it doesn’t want us to save too much. Thanks to generous tax breaks on pension contributions, the more we pay in, the more it costs the Treasury, and the lifetime allowance (LTA) is one way it caps the amount of money we can save tax-efficiently.
The LTA dropped to £1 million this tax year, down from £1.25 million last year and a much more generous £1.8 million in 2011/12.
Your pension benefits are tested against the lifetime allowance when you start to draw them from the scheme. If your total pension savings exceed the LTA at retirement, you will face a punitive tax charge on the excess. This is 55% if you take the money as a lump sum or 25% if you take it as income. These figures have been set so that the tax paid is broadly the same however you take the money.
The new £1 million limit, which has been in place since 6 April, will clearly affect high earners. But many people who don’t perceive themselves to be particularly wealthy may also be caught out if they have spent a long career in the public sector and have a generous final salary pension. Philip Smith, a director at PwC says: “Police inspectors could get caught out, as well as head teachers, doctors and so on.”
While government figures suggest that only 4% of people will be stung, if you consider that there are around 11.5 million people approaching retirement aged between 50 and 65, at least 460,000 people could be affected.
Gary Smith, a financial planner at Tilney Best Invest, believes the numbers will only increase. It is an underestimate, he says. “It’s difficult to quantify the numbers affected but if you are, say, in your 40s, and paying in £1,000 a month, you’re going to hit the allowance.”
What to do if you think you'll breach the £1 million limit
The first step is to get a pension valuation. If you’re in a defined contribution (DC) scheme, in which your end pension depends on the amount of contributions and how they are invested, look at your annual statement. This should give you a current valuation for transfer purposes and an indication of what it will be worth when you retire.
Members of defined benefit (DB) schemes that provide a pension based on a formula related to your salary, need to take their anticipated pension income (which should be in your paperwork) and multiply that by 20.
So, once you are looking at retiring on an income of £50,000 a year, your pension would be valued around £1 million. But Gary Smith says it’s important to also factor in any lump sums “if they don’t reduce your starting pension,” as offered by the Teachers’ Pensions and NHS schemes, for example.
If you’re still a way off retiring, it’s also important to note that the LTA is likely to rise. Gareth Shaw, head of consumer affairs at Saga Investment Services, says: “From April 2018, it will be rising in line with inflation. Bear this in mind before taking action in other places.”
But Philip Smith questions how beneficial this uplift will be. “You would expect the value of your pension benefits to increase by more than the Consumer Prices Index.”
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Consider the government protections
Recognising it has moved the goalposts, the government does offer a degree of protection for those that have either breached or are approaching the new, lower LTA. This comes in the form of fixed or individual protection 2016 (known as FP16 and IP16).
Fixed protection enables savers to maintain an LTA of £1.25 million and is available to everyone. However, while FP16 is theoretically still available, in order to secure this limit savers are not able to make any further contributions after 5 April 2016. If you have paid in money since this date, you will no longer be eligible.
Individual protection, meanwhile, is available to those whose pension benefits exceeded £1 million at the end of the tax year on 5 April, but want to continue contributing. Gary Smith explains: “For those who qualify, their LTA will be set at the value of their pension benefits on 5 April 2016, subject to a maximum of £1.25 million. Unlike fixed protection, those who apply for individual protection will be able to continue to make pension funding in the future.
Angela Murfitt, a chartered financial planner at Fairstone Financial Management, says the decision on whether to apply for IP16 is fairly black and white. “If an individual had a fund in excess of £1 million on 5 April 2016 and did not hold any existing protections, it is likely that IP16 will be appropriate – there are no restrictions on making further pension contributions, so there is no downside of applying for the protection if it is available.”
The government is expected to allow savers to apply for protection online from July (the legislation is yet to receive Royal Ascent). However, Gary Smith says you should register your interest ahead of this date. “This will benefit those individuals who intend to retire prior to July,” he says, “but we would also strongly encourage all those who don’t intend to retire during this period to register their intention with HMRC as soon as possible. This means that should the unthinkable happen and the individual dies, it will offer the individual protection.”
Patrick Connolly, a chartered financial planner at IFA Chase de Vere, adds that it’s still possible to apply for protection introduced for previous LTA reductions. “Some people may also still be eligible to apply for individual protection 2014,” he says. “This would apply to those with pension funds valued at more than £1.25 million on 5 April 2014 and can provide a lifetime allowance up to a maximum of £1.5 million.
Other ways to save for retirement
Once you have reached the LTA, there are other ways to save tax effectively. The obvious starting point is an individual savings account (Isa).
Mr Shaw says: “You will be losing tax relief on your contributions, but when you come to take the money out it will be paid tax-free. This can be very helpful when planning your income in retirement.”
Following a rule change that allows savers to pass on money in pensions to their heirs free of inheritance tax (IHT), there is a greater incentive to draw some retirement income from vehicles other than your pension.
This tax year you can invest £15,240 into an Isa. However, that allowance will increase to £20,000 from April 2017. This means a couple can put away £30,480 this tax year and £40,000 from next year, says Mr Shaw.
VCTs provide finance for small UK businesses. To encourage investors, the government offers a 30% income tax rebate on your investment so long as you remain invested for five years. At this point, you can sell your VCT without incurring capital gains tax on any profits.
EISs also invest in smaller companies but unlike VCTs are not listed on the London Stock Exchange. They offer similar tax breaks, but the required holding period is three years.
But you could end up seriously out of pocket with these investments. Mr Shaw warns: “They can be attractive, but they are very much long-term investments and are often invested in start-up companies.”
Topping up your spouse’s pension may also be an option. Putting money away for a non-earning spouse gets you tax relief on the way in. If the income in retirement is less than the personal allowance, it may mean no tax is paid on the way out either.
Working out what to do will depend on whether you’re paying into a DC or DB scheme, what your earnings are, and how your employer pays into your pension, to name just a few of the many considerations you will need to make before you opt out of your pension.
Mr Cox says: “There is no one-size-fits-all solution. If you are close to retirement, you could quit the scheme, apply for protection and get your employer to pay its contributions as salary or bonus to avoid the tax charge.”
Should you retire early?
Some people in final salary schemes may use the lifetime allowance as an excuse to retire early. Gary Smith says members can typically expect to see their annual income reduce by 5% for every year they knock off their working life. “Retiring early is a legitimate planning tool,” he says.
But while you may get the benefit of quitting work early, there are risks to consider such as the solvency of your employer. Philip Smith says: “You only get full protection from the Pension Protection Fund if you retire at your normal retirement age.”
Opting out of your pension scheme may make less sense if you have many years before you retire. However tough a 55% tax charge might be to swallow, some advisers point out that it might be worth accumulating a bigger pension and simply paying the charge – particularly if you’re a higher-rate taxpayer and your employer makes generous contributions on your behalf.
Mr Connolly says: “It would be far better to benefit from ongoing employer contributions or achieve good performance and have, say, a £2 million pension pot, on which a tax charge will be applied, than stop employer contributions or not achieve good performance and have a £1.25 million pension with no tax charge.”
Philip Smith points out that in a DC scheme a higher- rate taxpayer could have £200 going into their pension each month at a cost of just £60 to them once tax relief and employer contributions are taken into account. With that £200 rolling up in a pension, getting taxed at 55% at the other end still isn’t that bad a deal,” he says.
Mr Cox says if you are still a way off retiring, the LTA isn’t sufficient reason to exit your pension. “There is always the chance that the LTA could be scrapped and you won’t be able to get back into the scheme,” he explains. “You also won’t get back the true value of your employer’s funding in salary and may miss out death in service benefits and other sickness benefits that may be tied in with the pension scheme.”
Gary Smith says the value of death-in-service benefits – which pay a lump sum if you die before reaching pensionable age – must not be overlooked, particularly if you are not married. “If you have been widowed or are divorced, your kids wouldn’t get anything.”
He spends a lot of time advising clients in the NHS pension scheme and as part of his analysis compares the impact of remaining in the scheme and doing nothing, opting out and applying for fixed protection and remaining in the scheme and applying for individual protection (see table above). “In 90% of cases, opting out is the worst option,” he says.
The situation will be more complicated again if you earn more than £150,000, as you would also have to consider the impact of the tapered annual allowance. This reduces the amount you are able to save into your pension each year from £40,000 down to £10,000 by the time your income reaches £210,000.
Nobody relishes a 55% tax charge and while individual protection may mean you don’t feel the full brunt of cuts to the LTA, it’s best to consult a specialist adviser before you quit your scheme. They will be able to take into account the minutiae of your pension scheme and your wider finances to maximise your retirement income and limit your charges.
Gary Smith adds: “Many pension savers will choose the opt-out option, but this does not necessarily represent the best outcome for them. I would encourage all those who are considering ‘protection’ to seek professional advice, as making the incorrect decision now could significantly impact on their long-term retirement plans”.
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The lifetime allowance dilemma: the adviser’s view
Patrick Connolly, a chartered financial planner at Chase De Vere, says: “The challenge from an advice point of view is that if we are concerned about clients breaching the LTA in the future then we could tell them to stop saving, but then the LTA could be scrapped and the client has missed out on additional pension contributions and potentially employer contributions too.
Alternatively, we could tell them to continue with pension contributions but they might get hit with a significant tax bill when they take benefits.The difficulty with making these decisions now is that we can’t even be sure what the pension rules will look like next year, let alone in 10 or 20 years’ time.”
The tax levied on the total value of your estate after you die. IHT has to be paid by the beneficiaries of your estate before they can receive any of the money from it. The money can’t be taken from the value of the estate _– it has to be paid before any money can be released. There is an IHT threshold – known as the “nil-rate band” – below which no tax is levied (£325,000 in 2011/12). Any amount above the nil-rate band is subject to tax at 40%. If your estate totals £600,000, there is no tax on the first £325,000; however your estate will pay 40% tax on the remaining £275,000, a total of £110,000. Prudent tax planning can reduce your IHT liability, so always consult a specialist solicitor.
Venture Capital Trusts were introduced in 1995 to encourage private investments in the small-company sector by offering tax relief in return for a minimum investment commitment of five years. A VCT is a company, run by a fund manager, which invests in other companies with assets of no more than £7m that are unlisted (not quoted on a recognised stock exchange) but may be listed on the Alternative Investment Market (AIM) or plus with the aim of growing the companies and selling them or launching them on the stock market. Investors in new VCTs are offered desirable tax advantages and VCTs themselves are listed on the London Stock Exchange, with strict limits laid down by HM Revenue and Customs on what they can invest in and how much they can invest.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
A catch-all phrase that can range from assessing the price of a property or vehicle before offering it for sale or the net worth of assets in an investment portfolio to the prices of shares on a stock exchange.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
Enterprise Investment Scheme
A scheme set up to encourage investment into small, unquoted trading companies and give investors tax breaks to compensate for taking risk. Because the companies in the scheme are not listed on a stock exchange they often carry a high risk, so the tax relief is intended to offer some compensation. An EIS company cannot be a subsidiary, must trade wholly in the UK, can’t employ more than 50 people and certain activities (including forestry, farming and hotels) preclude companies from offering EIS relief.
This is more usually a feature of car insurance but it can also crop up in contents, mobile phone and pet insurance policies. An excess is the amount of money you have to pay before the insurance company starts paying out. The excess makes up the first part of a claim, so if your excess is £100 and your claim is for £500, you would pay the first £100 and the insurer the remaining £400. Many online insures let you set your own excess, but the lower the excess, the more expensive the premium will be.
Final salary pension
A defined benefit pension scheme is one where the payout is based on contributions made and the length of service of the employee. A typical scheme would offer to pay one-60th (0.0168%) of final salary (the one you’re earning when you finally retire) for each year of contributions to the scheme (even though these years were probably paid at a lower salary). Someone retiring on a final salary of £30,000 who had been a member of the scheme for 25 years would receive a pension of 42% of their final salary (£12,300 a year before tax). Sadly, many companies are winding up their final salary schemes or closing them altogether, meaning pension benefits accrued after a certain date (or those available to new employees) may be on a less generous money purchase basis.
Capital gains tax
If you buy an asset – shares, a second home, arts and antiques – and then sell it at a later date and make a profit, that profit could be subject to CGT. You don’t pay CGT on selling your main home (which is why MPs “flipped” theirs so regularly) or any securities sheltered in an ISA. Individuals get an annual CGT allowance (£10,600 in 2010/2011) but if you have substantial assets it’s worth paying an accountant to sort it for you.
A financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.