One of the subtle tax increases introduced in the March 2021 Budget was a freezing of the pensions lifetime allowance until April 2026 at its 2020/21 level of £1.0731m. Like any freezing of an allowance, it is designed to produce extra tax as inflation and/or economic growth drag more taxpayers over the fixed threshold.
What is the relevance of the lifetime allowance?
The lifetime allowance sets a ceiling on the value of pension benefits, above which:
A 25% tax charge applies if benefits are drawn as income; or
A 55% tax charge applies on lump sum benefits.
The standard lifetime allowance was introduced in 2006 at a level of £1.5m and gradually increased to £1.8m four years later. Thereafter the value has either been frozen, cut, or, more recently, increased in line with inflation (prices, not the more logical earnings).
The Treasury’s interventions since 2010 have been designed to constrain pension savings and thereby reduce the tax relief it has to grant on contributions. It is a moot point whether the lifetime allowance itself was meant to produce tax via those two tax charges. Like much anti-avoidance legislation, the intention behind the lifetime allowance tax charge was to discourage action that could trigger a tax bill.
Growing more relevant
As the graph above illustrates, the number of people being caught by the lifetime allowance has increased sharply in recent years. The latest data, for 2018/19, shows an average tax charge of nearly £40,000. The lifetime allowance freeze is set to increase both those falling foul of the lifetime allowance tax charge and the average amount they pay.
In some instances, the lifetime allowance is unavoidable or worth accepting. For example:
If your employer will not offer a financial alternative to pension contributions, the choice is between a benefit net of the lifetime allowance charge (maximum 55% tax) or no benefit (effective 100% tax).
You may have a pension pot well under the lifetime allowance shortly before drawing benefits and then find a sudden spurt of investment growth pushes the pot’s value over the allowance. For example, a fund worth £900,000 on 25 August 2020 would have grown to £1,135,890 a year later, if it had moved in line with the FTSE All-Share Index.
In some cases, the lifetime allowance charge may be worth accepting as it is less than the combined value of income tax and employer national insurance (NIC) relief on an employer pension contribution.
ACTION
There have been rumours that the next Budget will see the lifetime allowance cut again, perhaps to as little as £800,000.
There are a variety of transitional protections which apply to the lifetime allowance that can be easily lost. How you draw your benefits can also help reduce or defer the impact of the allowance. If the value of your pension pot is, or could be, in striking range of the lifetime allowance, make sure you seek advice before taking any action, whether that be drawing benefits or making contributions.
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