Retirement can be a very uncertain time in one’s life. However, your finances don’t have to be.
You might be asking yourself what a lifetime allowance is.
It’s a limit on the amount of money you are allowed to take out of your pension. This limit applies before an extra tax charge has been triggered by HMRC1. Currently, this limit or the lifetime allowance is £1,073,100 for the 2020/21 tax year.
However, be aware of the consequences of going over the lifetime allowance, even though only a large pension pot holder will be affected by this law.
Let’s Visualise Lifetime Allowance
The lifetime allowance, as seen in the table above, went up to £1,073,100 in April 2020. What does this mean for you? This means that you can take out up to £1,073,100 of your pension pot during your retirement. Better yet, only after you exceed that amount will you be charged the lifetime allowance.
Both your personal or workplace pensions are under the lifetime allowance. Any defined benefit pensions or defined contribution pensions as well. The good news is that your State Pension allowance doesn’t fall under the lifetime allowance limit. You’ll pay tax on top of your income tax if you exceed the lifetime allowance limit.
Here’s How You Calculate Your Lifetime Allowance
When you start taking out of your pension pot, the amount you take out will be subtracted from your lifetime allowance. This withdrawal will be visible on your bank statements. Not everyone is affected by this limit (the lifetime allowance). However, it’s a good idea to work out how much you’ll be withdrawing from your pension once you retire. This will prevent any unexpected fees.
- Defined contribution pensions: this pension option is very common for many people. This option’s value depends on the amount of money you pay into the investment and how that investment performs. This value is under the lifetime allowance law when you withdraw cash from your pension.
- Defined benefit pensions: two key things affect the value of this option- your salary and the how many years you have been working for. It’s easy to see this value by multiplying your total yearly pension by 20. Don’t forget to add your tax-free lump sum to that as well, so long as you meet the requirements.
Learn More About Lifetime Allowance Charge
The amount of money you pay into your pension pit determines how much extra tax you’ll be paying once you exceed your lifetime allowance. When as a lump sum, you’ll have to pay55% tax on that amount. When you withdraw from your pension through drawdown or an annuity, you’ll have to pay 25% tax over and above the income tax you usually pay.
Lifetime Allowance Charge in Practice
This is how the lifetime allowance charge2 works:
- For example, if your pension id valued at £1,073,100, there won’t be an additional tax charge. Why? Because you are within your lifetime allowance (£1,073,100).
- Another example of how it works is if your pension is valued at £1,078,100, it’s possible to withdraw the first £1,073,100 before you have to pay tax. You’ll only pay tax to the excess of £5,000. £2,750 tax (55%) will be charged on a lump sum withdrawal. £1,250 (25%) will be charged on drawdown or an annuity, as well as income tax.
- The last example is that if your pension is valued at £2,000,000, you can draw the first £1,073,100 without having to pay tax. You’ll pay tax on the excess of £926,900. As lump-sum withdrawal, you’ll pay £509,795 tax (55%). As drawdown or an annuity, you’ll pay £231,725 (25%). And don’t forget about your income tax.
The When, Why & How of Lifetime Allowance Increases
Every year, the lifetime allowance is indexed. It is always according to the Consumer Prices Index (CPI). It’s expected that inflation may cause the lifetime allowance to rise for the 2021/22 tax year.
History has shown that the lifetime allowance rises and falls. In the past decade, its peak was £1,800,000, and its low was £1,000,000. Every year these amounts differ slightly, but it has a significant impact on savers who have larger pension pots that generate substantial tax savings.
You apply for ‘protection’ against tax charges. How? By building up benefits with high value. You can choose from a few; personal protection, primary protection, fixed protection, and enhanced protection.
Did You Know, Your Pension Will Get Tested?
Don’t fret; it isn’t as bad as it sounds. However, it’s always a good thing to know everything surrounding your pension. Your pension gets tested to see if it exceeds this lifetime allowance. Below is listed when your pension is tested and what is tested:
- The When: every time you try to access your pension, and on your 75th birthday, it’s tested.
- The What: the totalof your pension withdrawal is tested. It’s not only a lump sum or your income that’s tested, as you may think. This withdrawal, in turn, uses some of your lifetime allowance. At the age of 75, any untouched pensions, as well as drawdown, is tested as well.
Now, let’s look at this testing in practice:
- If your pension pot is valued at £100,000, you’d be able to withdraw a lump sum of £25,000 without paying tax on it. The rest will be used as income. So then the £100,000 will be tested according to your lifetime allowance. This amount is around 9.3% of a standard lifetime allowance.
- Say you withdraw £25,000 as an Uncrystallised Funds Pension Lump Sum (UFPLS). Only that amount will be tested. Another way of looking at that amount is to say it’s 2.32% of a standard lifetime allowance. Any remaining pension won’t be tested unless you withdraw again, or turn 75.
What Happens If My Pension Exceeds the Lifetime Allowance?
When your withdrawals exceed the lifetime allowance, you’ll be charged 25% tax on those withdrawals. If it is taken out as an income, that is—for example, an annuity or a drawdown. If you withdraw a lump sum, 55% tax will apply.
How Do You Work Out Your Lifetime Pension Allowance?
It’s very simple to work out your lifetime pension allowance at home. You can multiply your estimated annual pension by 20 (for defined benefit pension plans). Also, add any tax-free lump sum, when it’s added to your pension.
How Can A Pensioner Avoid Lifetime Allowance?
Retiring early or agreeing to a lower annual income are two ways of achieving that goal. Another way is to look for a pension plan which offers lower rates on any future accruing benefits.
How Do I Avoid Lifetime Allowance Charges?
If you’re taking funds from your pension pot earlier than your retirement, your pension size is bound to be less. It could be that the fund value is less than the lifetime allowance charges, in which case you won’t be asked to pay these charges.
With this lifetime allowance limiting you, it’s always good to know how it affects you and your pension. SO, now that you know all you need to know, your worrying days are over!