1st June 2023
general
What is the Lifetime Allowance?
The Lifetime Allowance was introduced in 2006 as part of Pensions Simplification. At the time, the annual allowance was £215,000, so it was felt that there should be a cap on overall pension funding.
The Lifetime Allowance started at £1.5 million and has gone up and down with successive governments. As of the 2022/2023 tax year, the Lifetime Allowance was £1,073,100.
Breaching the allowance would mean tax penalties of 55% if the excess was taken as a lump sum, and 25% (plus income tax) if taken as income.
A Lifetime Allowance test would apply only at the point the pension fund was ‘crystallised,’ for example:
Individuals with substantial pension pots were able to apply for various types of protection, firstly when the Lifetime Allowance was introduced, and later, when it was reduced. Depending on the type of protection, the member would either have a higher lifetime allowance, or would escape a Lifetime Allowance charge altogether providing they stopped contributing after a certain date.
For money purchase pensions, the amount measured against the Lifetime Allowance was simply the value of the pot. For defined benefit pensions, the calculation was more complex and could be difficult to keep track of.
How Will the Changes Work?
As of 6th April 2023, there will be no tax charge on breaching the Lifetime Allowance.
The plan is that as of April 2024, it will be removed from the legislation altogether. This means that there will be no restriction on the level of pension pot that can be accrued.
However, there is one important caveat. The amount of tax-free cash available will be capped at £268,275, i.e. 25% of the most recent Lifetime Allowance. Any benefits over this amount will be designated to provide a taxable income.
It is unclear how or when this amount will be reviewed, but given the Lifetime Allowance was due to be frozen until 2028, it’s reasonable to believe the same will apply.
Who Will This Affect?
The stated intention behind this was to make sure that senior employees, such as doctors, did not retire early due to tax concerns. Critics of the policy claimed that the number of doctors who were both impacted by the Lifetime Allowance and would be prepared to change their retirement plans solely on the basis of tax would be very small.
The new rules will impact anyone who already has a large pension pot or who is making substantial contributions. Individuals with personal or workplace pensions exceeding £1 million are in the minority, particularly as the value is easy to monitor and contributions could be diverted elsewhere. But this may change, particularly with the increase to the annual allowance.
The Lifetime Allowance was more of a concern for members of defined benefit pension schemes. A scheme member with a pension of more than £53,655 per year would face tax charges. Where the member also had a tax-free cash entitlement, the threshold would be even lower.
While public sector pensions and large company schemes are not as generous as they once were, higher earners with a long service history could still be impacted by the Lifetime Allowance and will benefit from the new rules.
As well as scheme members saving on tax, pension providers and investment companies will also benefit. People are likely to build up larger pension funds and hold them for longer, which will increase profits in the financial sector.
Other Limits on Pension Funding
Even with the scrapping of the Lifetime Allowance, there will still be some limitations on pension funding:
Will the Lifetime Allowance be Reinstated?
Pensions are already highly tax-efficient, and the removal of the Lifetime Allowance may mean that more people prioritise pension funding over other types of investment. Pension funds as a proportion of overall wealth are likely to increase.
The Labour party have been highly critical of the change, and have pledged to reinstate the Lifetime Allowance if they win the next election.
Pension legislation changes frequently and the rules are unrecognisable from the early days of ‘Pension Simplification.’ It’s possible that limitations will be loosened or tightened in the future depending on the government and public sentiment at the time. For example, tax-free cash entitlement may be reduced or even removed altogether. Pensions are not currently subject to Inheritance Tax, which makes them useful for estate planning – this could also change.
It's worth seeking advice around pension planning, particularly if you are a higher earner or are approaching retirement.
Please don’t hesitate to contact a member of the team to find out more about retirement planning.
