Hundreds of thousands drift towards costly pensions tax trap
Almost a year after the reduction of the pension lifetime allowance to £1m, growing numbers of workers risk tax shocks because they are unknowingly on course to exceed this limit.
Workers in their 40s and 50s with previous final salary type pension benefits are most at risk.
Rising stock markets and baffling rules make it hard for people to appreciate the danger. Despite calls to scrap the lifetime allowance, which has been called a tax on good investment performance, the Government has steadily reduced the cap.
There are annual and lifetime limits on the amount you can save into a pension. If you go over either allowance, HMRC claws back the tax relief added to all pension savings.
The falling lifetime allowance, coupled with rules so complex that they outfox even finance professionals (see below), also mean that savers risk losing “protections” that allow them to preserve higher allowances from previous years.
Telegraph Money has been inundated with correspondence from readers struggling to understand if and when they will break the limit and looking for help on what they can do.
Financial advisers also report rising numbers of clients who have unknowingly voided valuable protections that allow them to save up to the old limit of £1.25m.
Declan Smith, 40, who works for a large financial services company, is already concerned that he will break the allowance despite being more than 20 years from retirement.
“I try to save as much into my pension as I can each year because of the tax incentives”, said Mr Smith, “but by my estimation I could break the lifetime allowance by the time I’m 58 if the investments perform well.
“I’m not sure if I should keep contributing to my pension and risk the tax penalties, or save in a different way.”
All your private pension savings count towards your lifetime allowance. The state pension is excluded from the calculation.
You have to add your “defined contribution” savings - which are the most common type of pension scheme - to any entitlements to a defined benefit scheme.
The former is easy: you simply take the current value of your pension, easily found on your annual pension statement or on request from your provider. Defined benefit savings work differently, however.
You multiply your projected initial yearly income by a factor of 20 for each defined benefit scheme you are a member of, then add any defined contribution savings.
But schemes do not routinely provide you with the defined benefit calculation and will not be aware of any other pension savings you have - so it is up to individuals to keep track.
Spiraling costs have forced employers to close almost all defined benefit schemes in recent years but more than 10 million workers have some level of defined benefit pension.
In Mr Smith’s case, he has a defined contribution pot of £370,000 and projected income of £9,000 a year accrued from two defined benefit plans.
That means he has used £550,000 of his allowance and is likely to breach the £1m cap long before he retires.
There is another danger - not faced by Mr Smith - that some savers are blindly walking into. It concerns “protections” offered by HMRC that allow savers to retain the higher pension allowances of the past.
There are two types of protection - “individual” and “fixed” - and a different version for each tax year.
The former can be applied for only if the value of savings was at least £1m in April 2016, when the allowance was lowered from £1.25m to £1m. You can retain the lower of your pension value at April 2016 or £1.25m.
There is no minimum pension value required for fixed protection, which also allows you to keep the £1.25m allowance. But making any new pension contributions after April 5 2016 voids the protection and will see your allowance drop back to £1m.
Paul Archer, an independent financial adviser at WFI Financial, said one of his clients unknowingly had pensions worth £1.3m and had not stopped contributing.
Not only did that mean HMRC would take a tax charge on the £300,000 excess but the client could not apply for fixed protection. He could, however, have used individual protection but his pension was over £1m in April 2016.
Mr Archer said his firm had not previously seen cases like this but the lower lifetime limit meant more people were being caught, unaware that they had to include defined benefit schemes they might have forgotten in the calculation.
“If we had known, we could have stopped his pension saving and used the protections to guard £1.25m instead of £1m. If he wanted to keep saving we would have recommended putting money into other tax-incentivised schemes, such as venture capital trusts.”
The taxman levies a 55pc charge on any pension savings beyond the lifetime allowance if you take the pension as a lump sum, or 25pc if withdrawn as an income. In the latter case, income tax would also be applied at your marginal rate.
'The whole system of lifetime and annual allowances would benefit from radical simplification, and preferably the abolition of the lifetime limit altogether,' said Steve Webb of Royal LondonCredit: Rii Schroer
Accessing - or"crystallising", to use industry speak - your pension triggers a test against the value of your saving. If the amount you are accessing is over the allowance you face a tax charge. However, you can phase your withdrawals so that only a part of the entire pot is tested against the allowance.
Steve Webb, director of policy at Royal London, the pension company, said: “The fact that people can accidentally breach the lifetime limit for pension tax relief shows how absurdly complex the whole system has become.
“Growing numbers of people will now have a mix of final salary pensions from previous jobs and new pension pots that they are building up with their current employers.
“Understanding how to combine these two different sorts of pension and test them against HMRC limits should not rely on individual pension savers having to dig out the relevant rules and perform complex calculations.
“The whole system of lifetime and annual allowances would benefit from radical simplification, and preferably the abolition of the lifetime limit altogether.”
Are there any occasions when I should go over the lifetime allowance?
But pension experts warn against becoming overly concerned with breaching the allowance. For instance, employers must contribute to a workplace pension on your behalf under the "automatic enrolment" programme.
In this case, you and your employer put money into your pension, and the Government tops up the amount with tax relief.
The tax charge levied if you go over the allowance claws back only the tax relief - your and your employer's contributions are intact. Some large firms may offer you cash instead of pension contributions, but many will not. In this case, it makes sense to keep saving, if only to keep receiving the extra contributions from your employer.