At Smith & Williamson we listen to our clients' needs and structure our solutions to meet an individual's circumstances and objectives.
The purpose of this guide is to assist in identifying those who may be affected by changes to the lifetime allowance. We outline possible courses of action to avoid substantial tax charges to individuals on excess funds.
Changes to lifetime allowance
The lifetime allowance was introduced in April 2006 and is the limit against which an individual's pension arrangements must be measured.
Examples of when pension funds are measured against the lifetime allowance include when taking benefits, on death prior to drawing benefits, transfer to an offshore pension and at age 75, if a lifetime annuity has not been provided.
Since it was introduced, the standard lifetime allowance has gradually increased from £1.5m to £1.8m for the current tax year. However, with effect from 6 April 2012, the last five years of increases will be wiped out when the standard lifetime allowance returns to £1.5m. To compound this potential problem, the Government has not indicated when this limit will next be reviewed, if at all.
Anyone who elected for 'primary protection' before April 2009 will be unaffected, as £1.8m will continue to be used for the basis of those calculations. The new limit will also not apply to those who elected for 'enhanced protection', but it will potentially affect everyone else, including those already taking pension income through drawdown.
Tax charges for exceeding the lifetime allowance
Pension benefits in excess of the lifetime allowance attract a tax charge of either 55% if these are taken as a lump sum or 25% if they are used to provide an income which would then be subject to income tax.
As a result of the reduction in the lifetime allowance, we anticipate more and more pension savers will gradually be drawn into this tax net.
Elect for fixed protection?
In recognition that individuals may have already accumulated pension funds in excess of £1.5m or expect to, it is possible for individuals to elect for 'fixed protection' with HM Revenue & Customs (HMRC) by 5 April 2012.
This preserves the previous lifetime allowance of £1.8m. Funds in excess of £1.8m will still attract tax charges but, potentially, electing for fixed protection could save an individual up to £165,000 in tax on excess pension funds between £1.5m and £1.8m.
As a condition of fixed protection, individuals have to stop pension contributions and cease to accrue further benefits in their employer's pension scheme from 6 April 2012.
Will I be affected?
If the total value of your pension benefits currently exceeds £1.5m, or is close to this limit, and you have not previously taken steps to protect your pension funds, you are likely to be impacted by these changes.
However, even if your pension savings are below the £1.5m mark right now, it is quite possible for someone in their 30s or 40s to have already amassed pension savings that could be worth over £1.5m by the time they retire.
The table shows how many years it would take for a pension fund to exceed £1.5m, assuming no further contributions are paid.
Each time that you crystallise a new pension benefit you use up part of your lifetime allowance.
Individuals who are currently receiving income through pension drawdown will already have had the value of their arrangements assessed against the lifetime allowance, but this will be subject to a further test at age 75 and therefore consideration still needs to be given as to whether fixed protection is required.
What action do I need to take?
You should initially consider when you expect to have finished crystallising your pension benefits. It is then imperative that you collect information on all of your pension investments which have typically built up through various providers and employers. This is likely to take some time and it is essential to start the process now to avoid the possibility of losing out.
You should also consider whether the value of your pension investments has been temporarily depressed as a result of market volatility and whether there is a danger of underestimating their potential future value.
How are my pension benefits valued?
Certain pension benefits may have a deemed value that is not immediately apparent.
Money purchase (defined contribution)
The value of money purchase funds, such as defined contribution occupational schemes and personal pensions, are applied directly against the lifetime allowance.
Final salary (defined benefit)
For final salary schemes, the annual pension amount is multiplied by a factor of 20 and any additional taxfree pension commencement lump sum is added to determine the value.
Lifetime pension annuities in payment
Pension annuities commencing after April 2006 will already have been valued against the lifetime allowance, leaving a reduced limit to be applied against future benefits. You should have received notification of the amount of lifetime allowance that has been used from your annuity provider.
For pensions that came into payment prior to April 2006, the current annual pension amount is multiplied by a factor of 25 to establish the value to be applied against the lifetime allowance when further pension benefits are taken.
Income drawdown
For drawdown arrangements that came into payment prior to April 2006, the maximum Government Actuary's Department limit is multiplied by a factor of 25 irrespective of the actual level of income taken from the arrangement.
Income drawdown arrangements commencing after April 2006 will already have been valued against the lifetime allowance. However, if a lifetime annuity has not been purchased prior to age 75, a further test against the lifetime allowance will be applied.
What should I do?
There are three key ways to take advantage of the current higher lifetime allowance.
- Individuals can elect for fixed protection for funds up to the current lifetime allowance of £1.8m. This election must be made by 5 April 2012 and individuals must stop pension contributions and cease accruing further benefits under their employer's pension scheme.
- Individuals aged 55 or more may consider starting to draw benefits before 6 April 2012, while the lifetime allowance is still £1.8m.
- Make additional contributions before 6 April 2012 and then take up one of the options above. Given that individuals can now get tax relief on contributions up to £50,000 per year and, in addition, may be able to carry forward unused contribution allowances from the previous three years, maximising contributions now and then electing for fixed protection or taking benefits may prove valuable for high earners.
Potential pitfalls
In order to qualify for fixed protection, no further pension contributions can be paid or new benefits accumulated.
The decision as to whether or not to register for fixed protection may not be straightforward, particularly for those who are members of generous employer-sponsored schemes. Members of defined benefit schemes would have to opt out of future accrual, which is not a step to be taken without detailed consideration.
The potential tax penalties of exceeding the lifetime allowance need to be weighed up carefully against the value of future pension benefits being given up and the cost of replacing these. It may be necessary to re-negotiate employment contracts, so advanced planning is essential.
For individuals who have registered for fixed protection, care also needs to be taken that this is not inadvertently affected by auto-enrolment in an employer's pension scheme in the future.
Auto-enrolment is being phased in for employers from 1 October 2012. It ultimately obliges all employers to automatically enrol all employees aged between 22 years and state pension age with earnings equal to or greater than the personal allowance into a pension scheme and pay contributions on their behalf. Individuals who have previously registered for fixed protection will only have one month to opt back out of the pension scheme before their fixed protection is revoked.
The majority of death in service schemes are also written under pension scheme rules. Individuals opting for fixed protection can remain a member of an existing death in service scheme if they joined prior to 5 April 2012, but would lose fixed protection if they joined a scheme after this date.
How do I apply for fixed protection?
HMRC has produced a particular form which individuals wishing to register for fixed protection will need to complete. Form APSS227 can be requested from HMRC or downloaded from its website.
It is important to note that while forms can be downloaded, it is not possible to apply online and paper applications must be received by HMRC on or before 5 April 2012.
How can Smith & Williamson help?
Successfully registering for fixed protection could save an individual up to £165,000 in future tax charges and we would encourage individuals who feel they may be affected to contact us for assistance and advice.
This guide is not intended as a replacement for professional advice.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
