Should I be worried about the lifetime allowance?

The lifetime allowance is the maximum amount you can build up in pension benefits over your lifetime without incurring a tax charge.

Any pension benefits above the LTA will be subject to the lifetime allowance charge of 55% if taken as a lump sum or 25% if taken as income.

As the graph below shows, the value of the pension lifetime allowance (LTA) has been moved around dramatically over the past decade. Most recently, in the Spring Budget of 2021, the Chancellor froze the LTA at its current rate of £1,073,100 up to and including 2025/26.

It is expected that from 2026/27, the LTA will once again increase in line with inflation, as measured by the Consumer Price Index (CPI).

Lifetime Allowance amount over time

While a £1m pension pot may seem substantial and unachievable, as pensions benefit from investment growth and compound interest, there is a danger that even a pension worth around half the current level of the LTA has the possibility of falling foul of the tax charge over time, as we’ll explore in more detail below.

And if you are a member of a defined benefit scheme, there is the added complication of actually figuring out how close you are to your lifetime allowance. The value of a defined benefit scheme can be calculated by multiplying your expected annual pension by 20, with the addition of any separate tax-free cash lump sum added on.

If you have a defined benefit scheme as well as a defined contribution scheme, then the value of both schemes together will be used to calculate the lifetime allowance. The state pension is not included in the calculation.

Assuming that the LTA remains frozen until the 2026/27 tax year and then increases by CPI thereafter (the Office for Budget Responsibility expects the CPI to be 2%), what level does a pension need to be at today to hit the charge?

   

Pension value in 2022 to hit the LTA in 5 years

£857,648

Pension value in 2022 to hit the LTA in 10 years

£741,914

Pension value in 2022 to hit the LTA in 15 years

£641,869

Pension value in 2022 to hit the LTA in 20 years

£555,271

Pension value in 2022 to hit the LTA in 30 years

£415,577

*Assumes 5% growth per annum net of charges, without any personal or employer contributions

The calculations show that even someone with a £500,000 or £600,000 pension pot, around 15 to 20 years from retirement may well be forced to hand over some of their hard-earned cash to the taxman. This is all down to the power of compound interest, which means the LTA is easier to hit than many people think.

And if you or your employer are making contributions to their pension as well, then you’ll hit the LTA even sooner.

If you believe you are at risk of hitting the LTA, then you’ll need to have a solid plan of action. If possible, you should seek finance advice to ensure you are making the best possible decisions for your personal circumstances.  

However, there are four things you could do to try to avoid hitting the LTA:

  • Use ISAs: Instead of contributing to your defined contribution pension, you could instead contribute to an ISA, if you have any allowance (up to £20,000 a year) remaining. However, if you are part of a workplace pension scheme, it is more than likely that you should continue to accrue benefits within the scheme to benefit from the employer contribution, even accounting for the lifetime allowance charge. However, it is important to know how much you may be required to pay to benefit from the employer contribution (some workplace schemes don’t require an employee contribution to still benefit from the employer contribution).
  • Use a spouse’s pension: If you are at risk at hitting the LTA, it might be worth considering redirecting your contributions into your spouse’s pension instead of your own. Of course, this is not risk free given it introduces the danger of divorce, but it does essentially double your lifetime allowance given you can use your spouses’ allowance as well.
  • Check if you have any protections: When the government reduced the LTA previously, they did at least offer some protections to allow certain people to keep the older, higher LTA. You can apply for Fixed Protection 2016 if you have not made any pension savings since 5 April 2016, and you’ll get an LTA of £1.25m. You may also be able to apply for Individual Protection 2016 if your pension savings were worth more than £1m at 5 April 2016, and you’ll get an LTA of the lower of £1.25m or the value of your pension rights at 5 April 2016.
  • Consider the timing of taking your pension benefits: When you take pension benefits your pension funds are tested against the lifetime allowance. It may be worth seeking the help of a financial adviser to understand whether there is a strategy to help reduce the impact of the lifetime allowance tax charge whilst still meeting your retirement income needs.