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Tuesday 14 March 2023 10:23 am  |  Updated:  Tuesday 14 March 2023 10:24 am

Pension explainer: The lifetime allowance and why it’s not just for wealthy savers

By: Samantha Downes

Speculation is growing that the Chancellor of the Exchequer Jeremy Hunt is looking at increasing the pension lifetime allowance (LTA).

The move is being interpreted as attempting to reverse the trend of early retirements and get more over 50s to consider re-joining the workforce.

Mr Hunt is keen to bolster Britain’s workforce as he looks to deliver on the Prime Minister’s pledge of growing the UK’s stalling economy.

Pensions experts, claim that by freezing the allowance and then subsequently lowering it, the government has penalised pension savers over the last decade.

They also argue that pension savings are used to invest in the wider economy as well as individual companies.

Phil Bevan, head of financial Planning at Saltus, said freezing the LTA was dampening economic growth and reducing the level of skilled workers in the UK.

He said: “Pension funds invest in the UK infrastructure yet our existing taxation approach disincentivises large individual pension savings.

“Senior doctors and consultants are leaving the NHS as the LTA negatively impacts their incentive to work. The unfortunate reality is that if we value brain surgeons, we need be prepared to pay for them. Removal of the LTA would be a superb move to inject growth and attract new talent.

“So removal of the lifetime allowance (LTA) completely or, at least, unfreezing the LTA and reapplying CPI indexation to the current level would be welcome.

“It should not be forgotten that the LTA was at £1.8m in the 2011/12 tax year and has since declined rapidly before flatlining and being frozen.

“Yet, we have had considerable inflation pressures over this period. Had the LTA simply tracked inflation, it would now stand at just over £2.4m.”

Carl Emmerson, deputy director at the Institute for Fiscal Studies said the lifetime allowance and, in particular, the annual allowance people can save into a pension are both badly designed and in need of reform.

“The annual allowance hits those who want to make large but infrequent pension contributions and can provide terrible incentives for high earners that have inflexible defined benefit arrangements. Both have been cut dramatically since 2010, raising the exchequer an estimated £8bn a year in additional revenue. 

“Increasing them will reduce the damage they do, but even better would be a more thorough reform of how pensions are taxed. High earners with big pension pots do benefit from inappropriately generous tax treatment of pensions, but there are much better ways of restricting this that these crude limits.”

Budget: What does Hunt have in store for pensions

Chancellor Jeremy Hunt is said to be planning to increase the lifetime allowance from £1,073,100 to over £1.5 million

The annual allowance could also be hiked from £40,000 to £60,000, while the money purchase annual allowance (MPAA) could rise from £4,000 to £10,000.

Pension and investment platform AJ Bell wrote to the Treasury last year warning the low level of the MPAA risked running counter to efforts to increase employment levels among older workers

Tom Selby, head of retirement policy at AJ Bell, comments: “After over a decade of persistent cuts to retirement savings incentives by successive governments, this finally looks like it could be a Budget that boosts pensions for hard-working Brits.

“Raising the lifetime allowance beyond £1.5m and the annual allowance to £60,000 would significantly reduce the risk of NHS staff being hit with a pensions tax charge for working extra hours. However, both the lifetime and annual allowance apply across all types of private pensions and so this announcement would increase the retirement savings limits for millions of Brits.

“It’s worth remembering that in 2010/11 the lifetime allowance stood at £1.8m and the annual allowance £255,000, so even these increases wouldn’t take us back to those halcyon days. Nonetheless, any rise in allowances would represent a major and welcome departure from recent trends.

“The money purchase annual allowance (MPAA), which applies to those who flexibly access their private pension post-55, is set at such a low level it risks acting as a significant disincentive to work. Given the challenges facing the UK economy this is clearly undesirable, and so raising the MPAA back to £10,000 – the level it was originally introduced at in 2015 – would be a sensible, pragmatic step.”

What are pension allowances and how do they work

What is the lifetime allowance?

The lifetime allowance caps the total amount you can save in a pension without having to pay an additional tax charge.

While the current level is just over £1m, over the years successive governments have whittled the figure down in a bid to raise revenue for the Exchequer; iin fact back in 2011/12 the figure was as high as £1.8m, points out Selby.

Each reduction in the lifetime allowance has resulted in the creation of a new set of ‘protections’, allowing some people to keep a higher personal lifetime allowance.

Your pension savings will be tested against the lifetime allowance when a ‘benefit crystallisation event’ occurs. These events include taking tax-free cash, buying an annuity, entering drawdown, starting a scheme pension (if you have a defined benefit pension) or taking an ad-hoc lump sum (sometimes referred to as ‘UFPLS’).

A test will also be carried out on your 75th birthday if you have funds that haven’t been used to buy an annuity or provide a scheme pension – including any growth your fund has enjoyed if you have chosen to remain invested in retirement in drawdown.

How the lifetime allowance charge works

If you breach the lifetime allowance, a charge will be applied to the excess. This charge will be 25 per cent iff the money is left in the pension or 55 per cent if taken out of the pension.

Selby said: “Take, for example, someone who breaches the lifetime allowance by £1,000. If the excess is left in the pension, a 25% charge will be applied, reducing the fund to £750. When these funds are later withdrawn, if income tax is paid at 40%, the amount the person will receive after tax will be £450.

If the person instead takes the £1,000 out as a lump sum, they will pay a 55% lifetime allowance charge (and no income tax), meaning they also end up receiving £450.

For this reason, if you expect to pay less than 40 per cent tax on your withdrawals it can make sense to keep your excess in the pension and pay the 25 per cent charge.

What are the annual allowance and money purchase annual allowances?

The annual allowance limits the total amount you can contribute to a pension without paying any tax and this includes personal contributions, employer contributions and tax relief.

It is currently set at £40,000 a year.

The money purchase annual allowance applies to anyone who has ‘flexibly accessed’ taxable income from their pension.

Once triggered, it reduces your annual allowance from £40,000 to just £4,000. It also removes the ability to ‘carry forward’ unused annual allowances from the three previous tax years.

The term ‘flexibly access’ mainly refers to taking income via drawdown, where your pension is invested and you take an income to suit your needs, or ad-hoc lump sums direct from your DC pot. Taking an income in DB or buying a lifetime annuity won’t trigger the MPAA.

If you breach your annual allowance, you will face an annual allowance charge designed to remove the upfront tax relief your contribution would have received.

That means a basic-rate taxpayer would pay a 20 per cent charge, a higher-rate taxpayer 40 per cent and an additional-rate taxpayer 45 per cent.

Can you access your pension without triggering the MPAA?

There are a few other ways to access taxable income from your pension without triggering the MPAA:

1. Just take your tax-free cash. While accessing taxable income flexibly from your pension will trigger the MPAA, withdrawing your tax-free cash won’t. It is possible to ‘partially crystallise’ your fund so you just take out the tax-free cash you need, with the rest left in your fund and able to grow tax-efficiently.
2. Take a small pot withdrawal. If your fund is worth £10,000 or less you can withdraw both the tax-free and taxable element flexibly without triggering the MPAA. You must extinguish the entire fund in order not to trigger the MPAA. You can take up to three small pot withdrawals worth £10,000 or less from personal pensions in your lifetime and an unlimited amount from workplace pensions.
3. Capped drawdown. Capped drawdown is no longer available, but some savers who were in capped drawdown before April 2015 have remained in it. Provided any withdrawals taken via capped drawdown do not exceed the maximum income limit (150 per cent of the GAD annuity rate), the MPAA will not be triggered.

How allowances have changed since 2010:

Source: AJ Bell; HMRC