Saving in a pension scheme so we are not a burden on others should be encouraged by the Government, not penalised. However, today one can only muster £1,073,100 before facing a 55pc tax charge. This is despite the flat £40,000 annual pension contribution allowance being more than sufficient that individuals do not benefit from excessive tax relief.
Many believe that they will not need to worry about the lifetime allowance, but analysis by Royal London, a pension company, estimated 1.25million of us would be caught by the time we retire.
The limit was introduced by Gordon Brown in April 2006 at £1.5m to simplify pension tax rules. Mr Brown was, of course, responsible for a notorious raid on pension funds in 1997, but almost a decade later Treasury minister Ruth Kelly said only 5,000 of the richest people would be caught.
Since then huge numbers have been hit by tax charges as the limit has been reduced. It is a regrettable example of the way governments introduce a new tax below the radar of most voters and then allow the scope to expand when they need to raise some extra revenue. Had Mr Brown's £1.5m limit risen with inflation it would today be about £2.3m.
Today one can only muster £1,073,100 before facing a 55pc tax charge.
Pension savings of £1,073,100 may sound a lot but consider what it buys you. According to Retirement Line, an annuity company, the best offer currently available for a man of 65 for a conventional lifetime annuity with this amount would be £51,678 per annum.
If you want it linked to inflation it would generate just £34,700 a year, enough for a comfortable retirement perhaps but not much more.
I also have concerns about the complexity. Your pension is tested against the lifetime allowance each time you take benefits in no less than nine possible scenarios, known as benefit crystallisation events or BCEs.
These include becoming entitled to a pension, buying an annuity, drawing a lump sum and putting funds into drawdown.
You are also tested at age 75 regardless. I will reach this milestone next year (all being well), along with 720,000 others, so the way the lifetime allowance charge works is of direct personal interest.
I initially decided to try to work this out from the legislation, as all good tax accountants should do, but I must admit that I found it a difficult read.
To double check I then ploughed through 137 pages of the HM Revenue & Customs guidance manuals. With the benefit of that and a cold towel, I think I now understand how it works, but it really should not be this complicated.
In practice your pension fund manager will provide HMRC with details of any BCEs, and the tax authority will test this against your lifetime allowance. If caught you then have two choices.
You can take out a lump sum and pay 55pc in tax personally or you can ask the fund to pay the charge at a 25pc rate - this lower rate applying because the remainder will suffer income tax in due course. Your pension provider should send you an annual statement, which includes a note of what percentage of your lifetime allowance has already been crystallised.
This should help you plan ahead so that you are not caught out with a tax charge to report unexpectedly. For example, when I was 65 I used £375,000, which was 25pc of the then £1.5m lifetime allowance, to buy an annuity at an attractive rate.
I stopped contributions in March 2016 and elected for fixed protection so my lifetime allowance is now £937,500, being 75pc of £1.25m. By adding the tax-free lump sums already taken to my drawdown fund I can compare this with my allowance to assess whether I am likely to be caught next year.
A key point to remember is that you may not be limited to the standard lifetime allowance. Provided neither you nor your employer have made contributions since April 5 2016 you could still be eligible to apply for fixed protection at £1.25m.
It is important not to allow this to put you off pension saving. If you are a member of a company scheme where your employer matches your contributions you will almost always be better off, even with a 55pc charge.
Once again, however, the self-employed are likely to miss out and may be better off with alternative saving arrangements if they expect to break their lifetime allowance.
It is also important to remember the inheritance tax advantages of pension funds. In particular, at death any fund remaining can be passed to your children free of IHT and they can then benefit subject only to income tax.
If you die before age 75, and they draw the fund within two years, it can be completely tax-free, not that I am planning on this strategy personally.
Mike Warburton was previously a tax director with accountants Grant Thornton. Tax Hacks is published online at telegraph.co.uk/money on two Tuesdays a month Republished with permission from Telegraph Media Group Limited
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