How to identify if you are at risk of a pension tax charge and what you can do
27th April 2021
Someone aged 45, with a pension fund of £400,000 and a salary of £50,000, could have a pension fund of £1,381,000 by the time they retire at 65*.
As announced in the Budget, the Lifetime Allowance (the amount of savings which can be built up in a pension and receive tax relief) will remain at its current level of £1,073,100 until April 2026. It’s been predicted that an estimated 10,000 individuals with large pension pots will pay more than £22,000 extra in tax by 2024.
WEALTH at work believes that the Lifetime
Allowance (LTA) will typically affect one of the following three groups. By
highlighting this, it can help people identify if they may be at risk of
breaching it and receiving an unexpected tax charge, so that the appropriate
measures can be considered.
Those who are blissfully unaware
Most probably think that they
aren’t one of the lucky ones to have a pension pot valued at the current LTA
limit of £1.07 million or more – but it’s quite possible that the value of
their pot is far higher than they realise and they may have already breached
the allowance. This could particularly affect those who never check the
value of their pension, or haven’t done so for some time. Also, many people
with defined benefit (DB) pension schemes are unaware that their pension is
valued at twenty times their annual pension for LTA purposes, and so an annual
pension of £30,000 has a value of £600,000.
Also, any tax free cash received from the pension will also need to be
added to this figure and checked against the persons available LTA.
If a member of a DB scheme decides
to transfer their pension savings into a defined contribution scheme to take
advantage of the pension freedoms, the transfer values offered can be much
higher than the standard method of working out the LTA value. For
example, transfer values can be as high as forty times the annual pension, and
so, using the above example, an annual pension of £30,000 could have a transfer
value of £1.2m and therefore exceed the current LTA.
Those who think they are a long way off
This group believe that they are a
long way from breaching the LTA, but in fact aren’t. This is particularly the
case where people are making healthy contributions into their scheme and
perhaps receiving matching contributions. Positive pension fund growth as well
as a pay rise may easily push them over the LTA before they know it.
For example*, if someone aged 45
has a pension fund of £400,000 and a salary of £50,000, saves 5% of their
salary into their pension which rises by 3% each year and
receives employer contributions of 10%, it is possible for their pension
fund to reach £1,381,000 by the time they retire at 65. With the LTA presently frozen until April 2026,
you could easily end up exceeding the allowance by retirement.
*Assumes growth rate of 5% and excludes charges on
the pension plans.
Those who think they are protected but aren’t
Some people who have taken
protection measures and opted out of their workplace pension scheme to
safeguard their savings from a LTA charge, could still be at risk of a breach.
This is because of how the rules around auto-enrolment work, meaning that
employees are re-enrolled every three years.
Just one month’s contributions
could invalidate protection previously granted, without someone even realising.
Responsible employers will inform employees whom they plan to re-enrol, so that
they’re aware that pension contributions will be deducted from their monthly
pay, but this may not be the case.
There are some steps that people can take to either avoid or reduce the impact of the LTA:
Review current situation – If
they have already taken some pension benefits, individuals should start by
looking at a current pension valuation and assessing how much of their LTA they
have used. If they have more than one pension, they will need to add up what
they’ve accumulated across all their pensions to work out the full amount.
Consider alternative savings
vehicles – Individual
Savings Accounts and workplace share schemes are two tax-efficient savings
vehicles for people to consider saving in as an alternative, or supplementary
to a pension.
Opt-out – Some
people may choose to opt-out of their workplace pension scheme for LTA purposes
especially if their employer is offering cash in lieu of the employer pension
contribution. Also, people need to understand that a decision to opt-out should
not be taken lightly and that it could well be in their best interests to
remain active in their pension scheme despite a potential tax charge. If you
are considering opting-out then it’s best that regulated advice is received
from a suitably qualified adviser.
Take early retirement – A
simple way for people to avoid exceeding the LTA, or incurring further charges,
is to stop contributing into their pension and taking early retirement.
Director, WEALTH at work, comments;
“Whilst having over £1million in
pension savings may seem unrealistic to most, reaching the LTA could be closer
than many people think. This will especially be the case now that the allowance
has been frozen, as we will see more individuals reach the threshold over time.
And it’s not just high earners and those with defined benefit schemes that will
be affected, but those who have saved from an early age, and whose investments
have performed well. The tax implications could be drastic and could lead to
potentially many being hit with unexpected and sometimes unnecessary tax bills.
Many workplaces now offer support
to their employees in terms of financial education, guidance and regulated
financial advice. This approach helps people understand all their options
before making what could be life-changing decisions, therefore leading to
better outcomes for all.”
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Examples from WEALTH at work for someone in their 20s earning £20,000, £40,000 and £55,000 p.a.
13th April 2021
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