You’re probably aware of the pension lifetime allowance, or LTA. It’s the maximum value of pension benefits you can build up over your lifetime without incurring additional tax. The current standard allowance is £1,073,100. In the past it was higher, and some people have a higher protected LTA amount, possibly with restrictions on contributions. You might think that you need to avoid exceeding the LTA at all costs. But that’s not really the right way to think about it.
The LTA isn’t a penalty
The first thing to remember is that it’s not against the law to exceed the LTA. It’s nothing like tax evasion. It’s no more illegal than is getting a pay rise that pushes you into a higher income tax bracket. If your pension exceeds the LTA, that only means that you’ll be subject to an additional tax charge on the excess. Granted, we all wish that the LTA tax charge didn’t exist. But it’s no more sinister than any other kind of tax.
Exceeding the LTA means your pension has grown
Few of us would turn down a pay rise just because it meant we’d pay more tax. Yet some people seriously contemplate liquidating their entire pension fund into cash to avoid exceeding the LTA. Let’s say your fund value has grown to above your LTA. Would you rather have zero growth, or 45% of future growth? Put that way it’s obvious: 45% of something is better than 100% of nothing! And 45% is worst case.
Once your money is already in your pension fund, you certainly shouldn’t wish away its growth; the more growth the better. The question remains, though, as to how you should take the LTA into account while funding your pension.
Funding your pension
Under current rules, you’re allowed to invest up to £40,000 a year into a pension plan. Ignoring growth, and assuming you invested the full £40,000 every year, you’d exceed the standard LTA after 27 years. With even modest growth you’d exceed it much sooner. Of course not everyone can afford maxing out their pension contributions. But even at lower contribution levels, growth could mean you’ll eventually reach the LTA. We wouldn’t know in advance, because we wouldn’t know for sure what the growth would be.
Suppose your pension eventually exceeds the LTA. Then some of the later funding of your pension could, with hindsight, be considered over-funding. Let’s take an example of £1,000 over-funding. Assuming total pension growth since funding was 50%, the £1,000 will have grown to £1,500. Assuming this is converted into an income stream, it will first be subject to a 25% tax charge of £375, and the remaining £1,125 will be gradually paid out, subject to your marginal income tax rate. Had the £1,500 not been in excess of the LTA, there would have been no 25% tax charge, and 25% of the £1,500 would have been available as a tax-free lump sum, again leaving £1,125 to be paid as taxable income.
In other words, by potentially over-funding your pension, you risk losing 25% of what you put in. But had you not done so, you would have missed out on tax relief at your marginal rate. If your marginal rate was less than 25%, then you’d be worse off if you eventually exceeded the LTA. But if your marginal rate was more you’d always be better off. So it appears to make sense to fund your pension plan to the maximum if you’re a higher rate taxpayer, even if that risks eventually exceeding the LTA.
Should you try to avoid the LTA?
As we’ve just seen, if you’re a higher rate taxpayer it makes sense to ignore the prospect of exceeding the LTA, and fund your pension plan to the max. But if you’re only a basic rate taxpayer, you need to factor in the actual risk of breaching the LTA. If you know for sure that funding your pension would over-fund it, then it makes sense to maximise your ISA allowance in preference. If that’s already maxed out, then the decision between taxable investments and over-funding your pension plan is more finely balanced; you need to take account of potential capital gains tax.
But it’s hard to determine the actual risk is of exceeding the LTA in the future. It depends on how well your investments perform, how long you live, and when you decide to crystallise your pension funds, in whole or in part. And to complicate considerations further, you need to take into account that your pension plan is an inheritance tax shelter.
When planning for retirement, tax is not the only consideration. Good financial outcomes include having available cash for spending, and for some leaving a legacy. EvolveMyRetirement® is a smart app that can help you achieve the best outcomes, taking not only tax into account, but also the uncertainties of investment growth, inflation and longevity, as well as your personal goals and preferences.