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When building up pension benefits throughout your life, it’s important to know what the limit is, particularly if you want to maximise the use of the full tax benefits. Understanding what the pension lifetime allowance is and how it works is crucial, giving you the chance to protect it with pension lifetime allowance protection and avoid paying tax charges. Well, that’s what we’re here for. If you want to find out all you need to know about the UK pension lifetime allowance, check out our guide to pension lifetime allowance explained.

What is a pension lifetime allowance?

A common misconception is that the lifetime allowance is a limit- or cap- on the amount you can have in a pension without having to pay additional tax charges. If you go over the allowance, you’ll likely have to pay a lifetime allowance tax charge on either a pension income or lump sum. But how does the pension lifetime allowance work?

How lifetime allowance works

There’s no limit to the amount you’re allowed to build up in pension benefits, but checks can be carried out to find out if the value of your benefits is larger than the lifetime allowance – should you have built up more than the value of the lifetime allowance, you could face a tax charge.

Checks are often carried out when you start drawing a defined benefit pension, or when you take an income or a lump sum from a defined contribution pension. They’re also generally carried out if you transfer a pension overseas before the age of 75, you reach 75 and have a pension that’s either in drawdown or that you haven’t touched, or you die before the age of 75 and have pensions that you haven’t touched. Once you reach the age of 75, there typically aren’t any further checks.

Whenever you start taking a pension from one of your schemes, the value will be compared against your remaining lifetime allowance to find out if there’s any extra tax to pay. Simply add up the expected value of your pensions and you can see if they’re likely to exceed the allowance. However, you may have to consider how the value of your pensions may change between making the calculation and when you expect a check to be carried out.

How much is the lifetime allowance?

For the majority of people, the lifetime allowance in 2022/23 is £1,073,100. This will be frozen until at least April 2026. This applies to the total of any pension you belong to, including:

Protecting your lifetime allowance

There may be ways to protect your lifetime allowance and potentially avoid the lifetime allowance tax charge.

If you think your pension savings may exceed, or have exceeded, the lifetime allowance threshold, it may be worth applying for pension lifetime allowance protection and investigating whether you are eligible for a higher lifetime allowance – you’ll need an account for HMRC online services, after which you’ll be able to apply for two protection schemes, as follows.

Individual Protection 2016 (IP2016) is available only if the value of your pension savings as of 5th April 2016 was over £1 million. It’s also available for people who’ve already got protection under either the Enhanced Protection, Fixed Protection 2012, Fixed Protection 2014, or Fixed Protection 2016 schemes It’s not available to those who already have Primary Protection, or Individual Protection 2014. IP2016 gives you a personal lifetime allowance that’s equal to the value of your pensions on the above date, subject to a maximum of £1.25 million or the current lifetime allowance (whichever of the two is lower). Protection can be lost in several different ways, depending on whether your retirement income is provided by a defined benefit pension scheme or a defined contribution. You can continue saving into a pension too, but any savings above the level of your lifetime allowance will be liable for lifetime allowance charge.

Then there’s Fixed Protection 2016. There’s no minimum pension value needed to apply for Fixed Protection 2016 (FP2016), but unlike IP2016, it’s not available to those who hold Enhanced Protection, Primary Protection or Fixed Protection 2012/14. With FP2016, you get either a lifetime allowance of £1.25 million or the current lifetime allowance (if it happens to be higher). In theory, you can lose the protection in some instances. To avoid doing so, you need to have opted out of automatic enrolment – usually within a month – and have stopped making payments into any defined contribution pension schemes from 5th April 2016. Furthermore, it may be worth becoming a deferred member of a defined benefit scheme rather than an active one, however this shouldn't be done lightly as other benefits may be lost and you may achieve a net positive by staying in the scheme. Don’t forget that you can’t continue saving into a pension or building up benefits when you have this form of protection too.

Charges if you exceed the lifetime allowance

Should the total value of your pension benefits exceed the lifetime allowance, you’ll have to pay the lifetime allowance charge – which is essentially a tax on the excess. However, the charge will be a little different depending on whether it’s taken as income or a lump sum.

Take the excess as a lump sum, and it’ll be taxed at 55%. The pension provider or administrator should deduct the tax, paying it to HMRC, and paying the balance to you.

Alternatively, keep the money in the pension so that you’re taking an income from it – whether that’s flexible, as a scheme pension, or as a guaranteed income – and you’ll be looking at a 25% tax charge, on top of any income tax you pay on the income you receive.

For both defined contribution and defined benefit schemes, any lifetime allowance charge occurred during the member's lifetime usually paid by the scheme administrator will be deducted via the scheme benefits/funds. Any lifetime allowance charge on death, these must be paid by the beneficiaries.

Summary

While going over the UK pension lifetime allowance is likely to incur a charge, there are various effective ways of mitigating and managing this. It is important to note that any planning strategy is intertwined with other taxation - there isn’t a ‘one size fits all’ approach as it is linked to an individual's circumstances and objectives. For example, it may be beneficial to break the limit and suffer the charge, than other taxes which may be applicable. You may have options when it comes to protection, including Individual Protection 2016 and Fixed Protection 2016, both of which have benefits and drawbacks. However, either form of protection is likely to be better than getting a charge after a check’s carried out, if it’s found that you’ve gone over your lifetime allowance.

If you’re planning on protecting your lifetime allowance, you want the pension lifetime allowance explained further, or you just want to discuss and talk over your options, you may want to speak to a financial advisor. You can get in touch with The Private Office today for a free initial consultation.

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