It goes without saying that saving for your retirement is a good idea.
The State Pension is simply not going to pay enough for most of us to enjoy much comfort in our old age, which is why it’s so crucial to put some money aside yourself, likely through a personal pension.
Innovations like the workplace pension scheme ‒ where bosses are forced to open pensions for staff, and top up their contributions ‒ have been effective in getting more people into the pension savings habit.
However, a decision by the Government to freeze the amounts we can save in a pension without facing tax charges looks set to cost some savers billions.
What is the Pension Lifetime Allowance?
As the name suggests, the Pension Lifetime Allowance essentially sets out how much you can save into your pension over the course of your lifetime and enjoy tax relief on your saving.
The allowance has been cut repeatedly over the last decade.
Back in 2011/12 it stood at £1.8 million, but it has been reduced over and over again, to its current level of £1.073 million.
What’s more, the Government has said that the Pension Lifetime Allowance will be frozen at this point until the 2025/26 tax year.
What happens if you exceed the Pension Lifetime Allowance?
Surpassing the Pension Lifetime Allowance can be incredibly costly, as you will generally pay a tax charge on the excess.
The charge will vary based on how you access your pension savings; you’ll pay 25% of any income you take from your pension, or a massive 55% of any lump sum.
Doing the right thing
It’s easy to look at the lifetime allowance and think it won’t apply to you. It’s only a consideration for the mega-rich and they can afford to pay those charges, right?
The truth is rather different.
Ultimately plenty of people will end up with such a sizeable pot, simply because they have been diligent in their pension saving and enjoyed strong performance from their investments.
While that pot sounds enormous, it would only pay for an annual income in retirement of £40-50,000.
Sure, that means a comfortable adage but it’s not exactly a life of luxury, is it?
These pension savers have simply done the right thing, and face extraordinary tax bills as a result.
The question of inflation
In the last few years, the lifetime pension allowance has steadily been creeping up, in line with inflation.
This is sensible; as incomes grow, so too do our pension contributions.
After all, the workplace pension scheme works by putting aside a percentage of employees’ pre-tax incomes, rather than flat amounts.
And as those incomes go up, the amount being put into our workplace pensions increases.
That’s why freezing the lifetime pension allowance is effectively a stealth tax, dragging more and more people into facing whopping great tax bills because of being diligent pension savers.
Pensions firm Canada Life has crunched the numbers to get an idea of what the Pension Lifetime Allowance would look like if it increased with inflation over this frozen period, and the difference is pretty stark.
Based on inflation forecasts, it found that the allowance would have pushed past £1.4 million by 2025.
That’s significantly higher than the frozen limit pension savers face instead.
A big money spinner
Of course, one of the main reasons for the allowance to be frozen for such a long period is that this way it brings in greater sums to the Treasury.
The Government’s own estimates suggest that the freeze will mean an additional revenue of £990 million, though this may be somewhat conservative; Canada Life reckons that lifetime allowance duties will hit nearly £1.5 billion a year by the 2025/26 period.
That’s billions of extra pounds for a Government openly keen on regaining some of the money spent on Covid support schemes over the last few years.
What can I do to avoid being caught by the Pension Lifetime Allowance?
If you have a sizeable pension pot, and you’re wary about being caught out by the massive tax charges that come from breaching the Pension Lifetime Allowance, you do have a couple of options.
The first is obviously to stop saving for retirement in your pension, and instead, explore alternative assets.
While you will sacrifice the tax relief on your contributions, and perhaps contributions from your employer too, it may work out that putting your money into a different asset ‒ property for example ‒ is an acceptable alternative.
Alternatively, you can look to ‘protect’ a higher lifetime allowance.
Bizarre as it sounds, you can apply to the Government to have a bigger allowance, though there are certain criteria in place that you’ll need to meet.
For example, there’s ‘individual protection 2016’, which protects the value of your lifetime allowance at the value of your pensions on 5th April 2016 or £1.25 million, whichever is lowest.
Alternatively, there’s ‘fixed protection 2016’ which sets your lifetime allowance at £1.25 million but restricts you from saving any more into your pension.
You could qualify for this if you or your employer haven’t added to your pension since 5th April 2016.
These protections can be applied for directly through the Government’s website.