It was confirmed in the budget today that the Lifetime Allowance (LTA) will be frozen at a level of £1,073,100. Prior to this April it has been increased annually by CPI. So, what does this mean?
What is the LTA?
The LTA is the pensions tax free limit on savings. Essentially, the value of someone’s total pension savings is calculated and compared to the LTA at the time the benefits are put into payment. If it is under the LTA there is no issue, and no LTA pensions tax charge. If it is over the LTA there is an additional LTA tax to pay on the excess only.
This is most likely to impact those who are on a reasonable salary (or more) and have a chunky period of service in defined benefit schemes – such as the public sector pension arrangements.
The calculation of the LTA for these types of arrangements is pension taken multiplied by 20, plus any tax-free cash. Essentially, you need a pension of £50,000 per annum (ignoring cash) before you may be facing an LTA charge.
Capping the allowance is a way for the Government to claim a bit more tax. The impact on individual pensions is quite small. It certainly should not be a trigger for opting out or taking retirement benefits early. This is what we are most concerned about.
How does the LTA calculation work?
The value in excess of the LTA is the bit that is subject to the LTA tax, which is usually at a flat rate of 25%. This can be different where cash in excess of the tax-free limit is taken. So, consider this scenario:
Pension per annum at retirement: £48,000 per annum
Cash amount (tax free): £144,000
LTA calculation: (£48,000 x 20) + £144,000 = £1,104,000
When compared to the LTA of £1,073,100, this is £30,900 over the allowance. It is on this amount that LTA tax is payable at 25% – a tax liability of £7,725.
The pension scheme will pay this tax to the HMRC and in return, the member pension is reduced by £373* per annum. This is the figure before income tax is calculated.
If this person had opted out of the pension scheme at the point at which they reached the LTA, their benefits would be:
Pension per annum: £46,656.52
Cash amount (tax free): £139,970 **
* this is based on a factor of 20.67 – the actual factors will vary based on retirement age and the pension scheme
** this is assuming the default cash taken is 3 x the pension amount
Other options and considerations
Taking more cash and a lower pension can change the overall value, as can taking early retirement. In the above scenario, the individual can take a higher amount of cash and a lower pension, resulting in no LTA tax liability at all.
For anyone retiring in the 2021/22 tax year with a pension of £50,000 a year and who incurs an LTA tax charge, they would suffer a reduction in their monthly pension after tax in the region of £4.
In summary
Freezing the Lifetime Allowance is certainly not going to provide a benefit to anyone. It may mean that in the future some have a slightly higher LTA charge than they may have done previously. However, the overall value of the pension remains high. Crucially, in the case of defined benefit schemes, it is difficult and expensive to replicate elsewhere.
Individuals must understand and analyse their own position before making any decisions.
Footnotes
- The amount of tax free cash which someone can take is restricted at a max level of 25% of the LTA
- Where the cash taken is over 25% of the LTA, then the LTA tax on the excess cash is 55%
