Value of payouts from pension schemes
The lifetime allowance is a limit on the value of payouts from your pension schemes – whether lump sums or retirement income – that can be made without triggering an extra tax charge.
The lifetime allowance for most people is £1 million in the tax year 2017/18.
It applies to the total of all the pensions you have, including the value of pensions promised through any defined benefit schemes you belong to, but excluding your State Pension.
From 6 April 2018, the Government intends to index the standard lifetime allowance annually in line with the Consumer Prices Index (CPI).
Working out if this applies to you
Every time a payout from your pension schemes starts, its value is compared against your remaining lifetime allowance to see if there is additional tax to pay.
You can work out whether you are likely to be affected by adding up the expected value of your payouts.
You work out the value of pensions differently depending on the type of scheme you are in:
For defined contribution pension schemes, including all personal pensions, the value of your benefits will be the value of your pension pot used to fund your retirement income and any lump sum
For defined benefit pension schemes, you calculate the total value by multiplying your expected annual pension by 20. In addition, you need to add to this the amount of any tax- free cash lump sum if it is additional to the pension. In many schemes, you would only get a lump sum by giving up some pension, in which case the value of the full pension captures the full value of your payouts. So you are likely to be affected by the lifetime allowance in 2017/18 if you are on track for a final salary pension (with no separate lump sum) of more than £50,000 a year, or a salary-related pension over £37,500 plus the maximum tax-free cash lump sum
Note that certain tax-free lump sum benefits paid out to your survivors if you die before age 75 also use up lifetime allowance
Whenever you start taking money from your pension, a statement from your scheme should tell you how much of your lifetime allowance you are using up
Whether or not you take money from your pension, a check will be made once you reach the age of 75 against any unused funds or undrawn entitlements
Charges if you exceed the lifetime allowance
If the cumulative value of the payouts from your pension pots, including the value of the payouts from any defined benefit schemes, exceeds the lifetime allowance, there will be tax on the excess – called the ‘lifetime allowance charge’.
The way the charge applies depends on whether you receive the money from your pension as a lump sum or as part of regular retirement income.
Any amount over your lifetime allowance that you take as a lump sum is taxed at 55%.
Your pension scheme administrator should deduct the tax and pay it over to HM Revenue & Customs (HMRC), paying the balance to you.
Any amount over your lifetime allowance that you take as a regular retirement income – for instance, by buying an annuity – attracts a lifetime allowance charge of 25%. This is on top of any tax payable on the income in the usual way.
For defined contribution pension schemes, your pension scheme administrator should pay the 25% tax to HMRC out of your pension pot, leaving you with the remaining 75% to use towards your retirement income.
For example, suppose someone who pays tax at the higher rate had expected to get £1,000 a year as income, but the 25% lifetime allowance charge reduced this to £750 a year. After Income Tax at 40%, the person would be left with £450 a year.
This means the lifetime allowance charge and Income Tax combined have reduced the income by 55% – the same as the lifetime allowance charge had the benefits been taken as a lump sum instead of income.
For defined benefit pension schemes, your pension scheme might decide to pay the tax on your behalf and recover it from you by reducing your pension.
If you wish to avoid the lifetime allowance charge, it’s important to monitor the value of your pensions, and especially the value of changes to any defined benefit pensions, as these can be surprisingly large.
You might also wish to consider applying for protection if your pension savings is expected to exceed the lifetime allowance threshold.