The pinnacle of pension saving is within reach of an increasing number of retirees, but careful steps are needed to avoid danger.
Individuals who have made significant pension contributions over their career – and those with sizable benefits promised through final salary schemes – are in danger of being caught out by a government rule that puts a limit on the total amount that can be saved into a pension over a lifetime.
On 6 April 2016, the lifetime allowance will drop from £1.25 million to £1 million. The lifetime allowance is the most anyone can accumulate tax-free in their pension pot; the size of that pension pot is typically first tested against the allowance when an individual starts taking the money back. Once the limit is reached, further accrual becomes unattractive as savings are subject to a hefty tax charge of 55%.
A few years ago the lifetime allowance was £1.8 million. At that time, few individuals had pension values that were in danger of scaling such heights; the lifetime allowance was primarily a concern for retiring chief executives and company directors. But with the reduction to £1 million in April, the lifetime allowance will be just as likely to afflict long-serving civil servants, doctors and middle managers who have saved diligently and amassed a decent pension portfolio over their working life.
“If you think the value of all your pensions is over the lifetime allowance, or could exceed it in the future, you should calculate an approximate value,” says Steve Moy, wealth management consultant at St. James’s Place.
If you are a member of a defined contribution scheme, it’s easy to check the value as it’s on your annual statement. But if you have a pension that is being accrued in a defined benefit scheme, things are less clear-cut.
Defined benefit schemes offer a pension based on a proportion of your ‘final salary’ and length of membership. To convert the final salary pension figure to a notional capital value, you should multiply it by a factor of 20, and add the value of any tax-free cash you are entitled to. This can then be added to any other pensions you have and used to test against the lifetime allowance.
“I would say it’s best to see your financial adviser and let them work it out for you; they can then advise you on any necessary action,” says Moy.
Assuming you have more than £1 million in your pension, how can you protect yourself from a potential 55% tax bill? As in previous years when the lifetime allowance has dropped, the government has offered some shelter to savers who, through no fault of their own, find themselves exceeding the limit. This time around, sanctuary will be offered in the form of ‘fixed protection 2016’ (FP16) and ‘individual protection 2016’ (IP16).
If your pension savings are in touching distance of the current lifetime allowance of £1.25 million, you should arguably look at locking-in at this existing allowance. To do this, you need to stop all contributions (including those from your employer) before 5 April 2016 and apply for FP16. With this protection in place, you give up all future pension saving but you protect yourself from future falls in the lifetime allowance.
If you continue, or your employer continues, to make contributions on or after 6 April 2016, you cannot apply for FP16; you have to apply for IP16 instead. This allows you to retrospectively ring-fence your pension if it was between £1 million and £1.25 million on 5 April 2016. The value on this specific date will be your own ‘individual’ lifetime allowance; so if your pension was valued at £1.15 million on 5 April 2016, this will be your new lifetime allowance.
Moy says that in return for stopping your contributions, employers might offer to top up your salary or provide a cash alternative. But he also points out that making a decision to stop or continue contributions without first seeking advice would be a mistake.
“Appropriate action will depend on the individual,” says Moy. “In many cases it will be appropriate to stop contributions before 5 April and put one, maybe both, protections in place. In some cases, though, it might be more appropriate to continue making pension contributions and accept the tax charge,” he observes.
HM Revenue and Customs has indicated that, although for FP16 you need to stop all contributions before the next tax year, there will be no deadline for applying for FP16 and IP16. It has also stated that the lifetime allowance will rise by the increase in the Consumer Prices Index from tax year 2018/19 onwards.
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