The lifetime allowance changes on April 6 each year in line with inflation set by the Consumer Price Index (CPI).
For 2020-21, the lifetime allowance, or LTA for short, is £1,073,100.
The limit applies to all your UK private pensions. Your LTA limits may differ from £1.073 million if you have individual or fixed protection from 2016 when LTA rules changed.
Calculating Your Lifetime Allowance
The lifetime allowance is compared with the value of your pensions every time you are paid some money from one of the funds.
You can keep an eye on if your pension savings are coming close to the lifetime allowance by regularly monitoring the value of your savings.
The value is calculated differently for each type of pension, so you must figure out how much each group of funds is worth and then add them together:
Defined contribution pensions
Typically, these are more modern workplace pensions and most personal pensions.
Defined contribution, or DC pensions, pay outs are based on the value of the underlying funds which will rise and fall in line with the price of any pension fund investments. Because of this, the benefits are not guaranteed.
The pot is always the value of the fund which would or does pay any regular retirement income or one-off lump sums.
Defined benefit pensions
You can work out how much each defined benefit fund is worth by taking the forecast of your annual pension the fund is expected to pay and multiplying by 20.
This does not include any lump sums, which must be added separately.
Lifetime Allowance Red Flags
- Watch if your total defined benefit, or DB pension value, with no separate lump sum is approaching £53,655 a year
- Some tax-free lump sums paid to your loved ones if you die before the age of 75 are included in the lifetime allowance
- Once you reach 75 years old, the tax man will check if your pension savings break the lifetime allowance limit at the time
- The tax man will check your lifetime allowance is not breached when you start taking money from a pension
Penalties If You Breach The Lifetime Allowance
If your pension savings are more than the lifetime allowance, a penalty on the excess called the lifetime allowance charge falls due on top of any tax you pay on money from your pension anyway.
Don’t forget, the lifetime allowance limit that pension values are measured against is the one in force for the tax year when the test is carried out.
The cost of the penalty depends on how you received the money from your pension.
Lump-sum payments
Your pension provider will carry out the lifetime allowance test and deduct tax at a rate of 55% of any amount that exceeds the LTA.
Pension Income
Pension income covers regular payments taken from a pension, including buying an annuity.
The lifetime allowance charge is 25% of the excess amount.
But beware, you cannot avoid the 55% lifetime allowance charge by taking money from a pension as regular income if you are a higher rate taxpayer.
For example, if you plan to take £12,000 a year from a defined contribution pension as monthly income of £1,000, you will pay the 25% LTA charge as well as 40% income tax on the remaining income.
So, the charge reduces monthly pension income to £750, and then the 40% income tax charge takes around another £300, leaving £450 – a total tax charge of 55%.
If your defined benefit pension breaks the LTA, your provider will deduct tax at source and pay a reduced income.
Protecting The Lifetime Allowance
The government decided to change lifetime allowance rules in 2016, but this would have left many wealthy pension savers facing financial penalties for following official guidance, so anyone who had more than £1 million in pension savings on April 5, 2016, was granted protection that excluded them from penalties.
Pension savers who have breached the £1 million limit on that date can still apply for individual or fixed protection.
Individual Protection 2016
Individual protection was granted to pension savers who qualified for earlier enhanced or fixed protection between 2012 and 2016.
Individual LTA Protection gives retirement savers a new LTA to the lower of the value of their pensions on April 5, 2016 or £1.25 million.
The protection does not mean pension saving has to stop but breaching the new LTA level still attracts the LTA charge.
Fixed Protection 2016
Fixed protection sets the lifetime allowance at £1.25 million, but savers must:
- Stop saving into an auto-enrolment workplace pension
- Stop saving into any defined contribution pensions
- Consider leaving any defined benefit pension
Continuing to contribute could take your total pot over £1.25 million and trigger tax penalties.
QROPS And The Lifetime Allowance
QROPS are specialist offshore expat pensions that come with a built-in solution for retirement savers heading towards the lifetime allowance charge.
Two rules apply to transferring one or more UK pensions to an offshore scheme:
- Pension providers will test the value of funds transferred into a QROPS against the lifetime allowance.
If the fund exceeds the individual’s LTA, a tax penalty is applied
- Once a UK pension is transferred to a QROPS, LTS rules no longer apply and the fund can grow without any fear of triggering the LTA charge
This tax hack allows retirement savers with pension funds likely to breach the LTA a haven for their retirement savings – providing a transfer is made before the fund breaches the LTA.
Taking your pension as a lump sum to avoid the LTA charge
Another way to avoid the LTA charge if you are aged 55 years or older is to take the pension as a lump sum under flexible access and then reinvest the funds – but this could trigger tax on the withdrawal.
However, even at the 45% additional rate, tax paid will still be less than the LTA charge.
Combining Your Pensions
Pension consolidation means combining all your pensions into one.
If you have several workplace pensions that you have left behind over the years, it can be difficult to keep track of how they are performing and the income they will provide when you retire.
You may also find each pension has a different retirement age, which may not suit your plans.
But one of the most important reasons for combining pensions is cost. Older pension schemes are often pound-for-pound invested a lot more expensive to run.
Combining pensions while you are still working can have a big impact on your retirement income – providing you take professional advice and make the right decisions.
Don’t forget you can always combine several pensions but leave the ones with bonus benefits where they are.
You will have to speak to an IFA or the government’s for guidance if you are in a defined benefit scheme and the fund is worth more than £30,000.
Reasons To Combine Pensions
- Consolidating your pension savings under one roof leads to economies of scale.
- Moving to a QROPS or International SIPP immediately opens a door to many more investments across markets a UK pension cannot hope to offer.
Easy Access
Flexible access is always important to consider. If your workplace pensions do not start paying until you are 60 or 65 years old, combining them in a new scheme lowers that age to 55.
Under flexible access rules, you can access your money earlier to spend how you want.
This is worth thinking about if you are in poor health as you will have the money to give up work much earlier than planned.
Investment Control
Combining pensions gives more control over investments, while most modern pensions come with 24/7 access on the web or with a smartphone app.
Beating The Lifetime Allowance Tax Trap
Another important aspect of combining pensions is outsmarting the lifetime allowance.
If your pension savings are nudging the £1.073 million lifetime limit but still below the line, move them to a QROPS. Consolidating to an offshore removes the lifetime limit and allows the fund to grow to any size without penalty.
Keeping the pensions separate could see the total fund growing to more than the allowed lifetime allowance which attracts a 55% tax penalty charged against excess savings over the limit.
Better Financial Clout
Some small pension pots fall below the best rate annuity deals, so you may get a better deal If you combine them to make a bigger pot and then buy an annuity.
You can also keep tighter control of your annuity payments in one place rather than split over several pensions.
Don’t include a pension that has a guaranteed annuity rate in the consolidation because you could lose valuable income in retirement.
How High Fees Impact Your Retirement Cash
High fees and poor investment performance can severely reduce you pension pot.
Consumer magazine Which? shows how combining pensions can double retirement money with an example:
A worker aged 35 with £10,000 invested in a pension until the age of 65 with a fund charging 2% management fees and 5% growth is worth £23,720 on retirement.
The same £10,000 invested in a new pension charging a management fee of 1.5% but offering 7% growth would be worth £48,541 over the same period.
Reasons Not To Combine Pensions
- Under most circumstances, if you have a final salary scheme in your pension portfolio or where you work, keep it as you are likely to lose some valuable benefits.
- You would strip away guarantees like annual increases linked to the cost of living, preferential annuity rates that are better than those on the current market, and income for your spouse if you die.
- Many older pensions may include exit fees in the small print that are unlikely to make combining pensions cost-effective. Exit fees are capped at 1% from a saver’s 55th birthday.
- They may also include a tax-free lump sum on the retirement of more than the standard 25% paid by a UK pension and come with a critical illness or life insurance.
Trivial pot pursuit
Don’t combine pensions with pots worth more than £10,000. Savers can opt to take the cash from three pots of £10,000 or less without affecting their lifetime allowance.
If you are still paying into a pension
Flexible access can affect the amount you continue to save if you take money from the age of 55.
Before taking any money, the annual contribution limit allows you to save up to £40,000 a year while still receiving tax relief. This reduces to £4,000 a year once money is in drawdown.
Pensions You Can Combine
Retirement savers can combine many pensions into one fund, including:
- Workplace defined benefit or final salary pensions with income based on length of time with an employer and salary on retirement.
- Workplace or personal defined contribution pensions with income based on the value of cash and investments held in the fund
- Funded public sector pensions, like local government pensions
- QROPS offshore expat pensions
- SIPPs – both UK and international schemes
Pensions You Can’t Combine
- The UK State Pension is protected until state retirement age and the fund cannot be transferred or cashed in at any time.
- The same applies to unfunded public sector and civil service pensions covering roles like teachers, and nurses.
