How can I avoid breaching the lifetime allowance?

The lifetime allowance, moreover the issue of exceeding it, promises to become a problem for an increasing number of individuals. On 6 April 2016 the lifetime allowance was reduced to just £1 million.

This might sound like a significant sum, but to put this into some context: when the lifetime allowance was introduced following pensions A-day on 6 April 2006, the level was set at £1.5 million. The level then increased each year until it peaked at £1.8 million in April 2010; however following a reduction to £1.5 million in April 2012, the lifetime allowance has been steadily decreasing all the way down to the current limit of £1 million. From the 2018/19 tax year the lifetime allowance will be increased annually by the Consumer Prices Index (CPI).

Unless you previously applied for Enhanced Protection, which closed on the 5 April 2009, there is no guarantee that an excess tax charge can be avoided.

How and when will I be tested against the lifetime allowance?

The value of your pension savings will be tested against the lifetime allowance when a Benefit Crystallisation Event (BCE) occurs; there were originally 9 BCEs and there are now 13. Discussing each of the potential BCEs is beyond the scope of this article, however the most common BCEs will apply when you draw benefits, either in the form of income or from a pension commencement lump sum. A BCE will also occur if you die before taking benefits; furthermore if you have not taken all of your benefits by age 75, a lifetime allowance test will be carried out on your remaining benefits.

How will this work?

If you are a member of a defined contribution scheme, the value tested against the lifetime allowance is simply the value of your pension pot in that scheme. For members of defined benefit (final salary) schemes, the value is calculated as 20x the accrued pension plus any tax free cash that you received. If you have been drawing income since before 6 April 2006, the income is valued by multiplying by a factor of 25.

If the total value of all of your pension benefits exceeds the lifetime allowance, the excess will be subject to a tax charge. This will be 25% if the money is withdrawn as income or a whopping 55% if it is taken as a lump sum.

Is there any protection I can apply for?

If you don’t have any of the previously available protection measures in place, which are: Primary or Enhanced Protection; Fixed Protection 2012; Fixed Protection 2014 or Individual Protection 2014; you may apply for one or both of Individual Protection 2016 and Fixed Protection 2016.

Individual Protection 2016 (IP2016) is available for any person that has accrued pension benefits in excess of £1 million on the 6 April 2016. If IP2016 is granted the new protected lifetime allowance will be the collective value of your benefits on 5 April 2016. IP2016 will provide lifetime allowance protection for funds valued from £1 million up to the cap of £1.25 million; any benefits in excess of this amount will not be protected. If you hold IP2016 then you can continue to save into a pension scheme without affecting the protection.

Fixed Protection 2016 (FP2016) is available to anyone, regardless of the current value of their funds, who expects the fund value to be in excess of the reduced lifetime allowance at the point they crystallise their benefits. FP2016 will provide a fixed lifetime allowance of £1.25 million; however no further contributions to defined contribution pension schemes can be made and no further accrual is allowed within defined benefit (final salary) schemes, apart from those related to the increase (to protect against inflation) of benefits already accrued. The increases must remain within set limits.

When holding IP2016, you can only join a new scheme if the only reason for joining the new scheme is to receive a transfer of pension rights from another scheme.

Lifetime Allowance planning using QROPS

One potential solution, particularly for those with larger defined contribution schemes such as SIPPs, might be to consider a transfer to a Qualifying Recognised Overseas Scheme (QROPS).

The reasons for this can be explained as follows:

Drawdown pensions, such as SIPPs, are tested against the lifetime allowance twice; the first test is when funds are designated into drawdown (BCE 1), and then again in the following scenarios: if you start a scheme pension (BCE 2), purchase an annuity (BCE 4), upon reaching age 75 (BCE 5A), or on transferring to a Qualifying Recognised Overseas Scheme (BCE 8).

Only the increase in the value of the funds that were crystallised under BCE 1 are tested at the second designation; this ensures that there is no double counting.

When transferring to a QROPS, any chargeable amount that is identified over your remaining lifetime allowance will be taxed at a rate of 25% (and none at 55%). The reason being that even though the assets are transferred out of the scheme, they are not paid to the individual.

The good news is that under current rules, once the funds are transferred to a QROPS they will face no further lifetime allowance tests.

How can a QROPS help me to avoid breaching the lifetime allowance?

We can use the following example to help illustrate the point:

Mr Jones, 50, has a SIPP that is currently valued at £1.7 million and he plans to retire at age 60 or later.

Mr Jones applied for Individual Protection 2014, which provides him with a protected lifetime allowance of £1.5 million. The SIPP is invested in a portfolio of equities that Mr Jones manages; and he expects the fund to have grown considerably by the time he take benefits in 10 years time.

If his pension remains within the SIPP,  he is currently on course to face a lifetime allowance tax charge on the value of his funds that are in excess of his lifetime allowance. This excess will be taxed at 25% for funds that are withdrawn as income or 55% if taken as a lump sum.

Mr Jones expects to achieve a net investment return of 6% per annum from his funds; this puts him on target to have a fund of £3,044,441 at age 60. If he achieves his target growth, this would result in an excess of £1,544,441 over his protected lifetime allowance of £1,500,000; taking the excess as income would result in a tax charge of £386,110 (25%), or £849,442 (55%) if taken as a lump sum.

Transfer to QROPS

If Mr Jones instead transfers his SIPP to a QROPS now at age 50, this will trigger a Benefit Crystallisation Event (BCE 8) and the value of his SIPP will be tested against the lifetime allowance immediately.

The value of his funds that are in excess of his protected lifetime allowance (£1.7 million – £1.5 million x 25%) will now be subject to an immediate tax charge of 25%: this will be £50,000 and payable on the date of transfer to the QROPS.

Once the funds are within the QROPS they will not be subject to any further lifetime allowance testing and assuming the funds continue to increase as Mr Jones expects, he will have made a considerable tax saving when he comes to take benefits at age 60.

A requirement for specialist advice 

Pension planning is a very complex area and requires a thorough understanding of both the rules and regulations and the risks and implications involved before making any decision. First Equitable strongly recommends that you seek regulated financial advice regarding your personal situation if you are at risk of breaching the lifetime allowance either now or in the near future.

Nothing in this article should be construed as financial advice or a recommendation to take action based on any of the content discussed in this article. If you would like to speak with a pensions specialist please use the contact form and a member of the team will be in contact to discuss your individual needs.

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