Lifetime allowance catches smaller pensions than you’d think

While the pension lifetime allowance is due to reduce from £1.5m to £1.25m at the start of the next tax year there will be many individuals thinking that this change is not likely to affect them.

Lifetime allowance catches smaller pensions than you’d think

This is unsurprising as the figures appear very large when most people consider what they may have in their pension plans.

However, some may fail to understand how defined benefit (final salary) pensions are valued, and may therefore breach the new lifetime allowance limit without realising.

The consequence of exceeding the limit is a tax charge of up to 55% on the excess, and so – especially if you are in a final salary pension scheme – it is important to be aware of exactly what your pension is worth and if you are likely to end up above the new allowance.

Whilst any defined contribution (money purchase) pension is valued based on the total value of the plan when benefits are taken this is not the case with a defined benefit scheme.

Any pension income received from this type of pension is valued at 20 times the gross annual pension paid. Tax free cash paid out is valued just as any money purchase sum would be.

Below are examples of where a pension scheme member would find their pensions reaching the lifetime allowance limit.

Mary and George

Mary retires at age 60 and receives a final salary pension of £62,500 each year.

Valuation: 20 x £62,500 = £1.25m

George retires at age 65 and receives a pension of £50,000 each year plus he also receives a tax free lump sum of £150,000 from the scheme.

George has also been paying into an additional voluntary contribution scheme (AVC) and has a plan currently valued at £100,000.

Valuation: (20 x £50,000) + £150,000 (tax free cash) + £100,000 (AVC) = £1.25m

Any pension received above these sums would be subject to a tax charge. To see the effect of the tax charge we can take the above examples but assume the pensions received are a little higher.

Sandra and Alan

Sandra’s annual pension at retirement is £70,000. This gives a value of (20 x £70,000) £1.4m against the £1.25m allowance.

Sandra ‘s pension is therefore £175,000 over the limit. As she is receiving the pension as an income, the tax charge will be 25% and the scheme itself will pay the charge. The scheme will however reduce her pension to take account of the tax paid.

How much the scheme will reduce Sandra ‘s pension will depend on the scheme rules. A point to consider here is whether the scheme rules are very fair in their commutation factors (used to determine the amount of pension which needs to be given up in order to provide the lump sum).

Certainly, in many cases they are not consistent with current annuity rates and are therefore poor value. However, taking a not unusual but nonetheless poor value figure of 12:1 for commuting income to cash within the scheme we get the following reduction.

(£175,000 x 25%) £43,750/12 = £3,645.83

So, Sandra’s initial pension would be £66,354.17 and not £70,000.

Alan’s pension at retirement is £60,000 plus £180,000 of tax free cash. This together with his £100,000 AVC gives a total value of:

(20 x £60,000) £1.2m + £180,000 + £100,000 = £1.48m

He will therefore be (£1.48m – £1.25m) £230,000 over the limit.

If he took his AVC before the final salary pension all the tax charge will fall on the final salary scheme. If it is paid out as income the tax charge will be 25% as above and using the same commutation figure we get the following:

(£230,000 x 25%) £57,500/12 = £4,791.67 pension reduction

If the final salary scheme was taken before the AVC the following tax charges will apply:

(£60,000 x 20) + £180,000 – £1.25m = £130,000 excess over allowance

£130,000 x 25% = £32,500 tax charge

£32,500/12 (commutation factor) = £2,708.33 pension reduction

This would leave the AVC to be taken later. The lifetime allowance has already been used up so the whole of this will be subject to the lifetime allowance charge. As this plan is based on a fund value and not income, the tax charge is 55%. So the following charge will apply:

£100,000 x 55% = £55,000

This would therefore leave George with £45,000 left out of his AVC.

As can be seen, whilst the pensions mentioned here are not small, neither can they be considered excessively large. It is therefore easy to see how individuals may think that they are unaffected when in fact they could well be in for an unwelcome surprise.

Action can be taken to protect pensions against the reduction in the allowance but this action needs to be taken before 6 April 2014. Those with pensions likely to exceed the lifetime allowance when they retire should take advice at the earliest opportunity.

The information in this article is based on Towry’s understanding of proposed/current tax legislation.

Whether any tax will be payable, at what level it is charged and whether the individual qualifies for tax relief (if applicable) will depend upon individual circumstances and may be subject to change in the future.

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About Author

Andy James

Andy James is advice policy manager at Towry