I am speaking to more and more clients wanting to avoid the lifetime allowance charge.
It’s understandable. The lifetime allowance charge can involve some big numbers.
A 25% or 55% tax charge at the point you retire isn’t a nice prospect.
A few weeks back I wrote an article on how the lifetime allowance is tested again at age 75 and how to potentially avoid this test.
In this article I will focus on defined benefit pensions in particular and how taking your pension early could avoid the lifetime allowance charge at retirement and the consequences of doing this.
An example of how taking your pension early can avoid the lifetime allowance charge
A quick recap. The lifetime allowance is the total amount of money you can build up in pensions before being faced with the lifetime allowance tax charge
As pensions benefit from favourable tax treatment when you are building funds, the lifetime allowance aims to limit these benefits.
The current lifetime allowance is £1,073,100 (2021/22) and is now frozen for the next 5 years.
Now you may or may not realise that when it comes to defined benefit pensions (otherwise known as final salary pensions) you usually have the right to take this pension earlier than your ‘normal retirement date’.
It is likely that you would be able to take your defined benefit pension anytime from age 55 (changing to 57).
So, let’s look at an example of taking your pension early to avoid the lifetime allowance charge when taking the excess as income.
Andrew has a defined benefit pension income due at his normal retirement age 60 of £53,419 per annum and a lump sum of £160,257.
The lifetime allowance position at this point would be:
(£53,419 x 20) + £160,257 = £1,228,637
This is £155,537 over the lifetime allowance (£1,228,637 – £1,073,100) and therefore the lifetime allowance charge at retirement will be:
£155,537 x 25% = £38,884
In this example the pension scheme will pay the lifetime allowance charge before paying out the pension income. They will then reduce the pension income going forward.
In this case the future pension income is reduced by £1,795 per year to cover the lifetime allowance charge meaning Andrew’s new pension income in retirement is now £51,624 per annum (£53,419 – £1,795).
However, if Andrew was to take his pension 3 years earlier at age 57 his pension scheme would apply an early retirement factor and reduce his pension income and lump sum.
Pension income at 57 = £45,940
Lump sum at age 57 = £145,833
Now let’s look at Andrew’s lifetime allowance position at age 57:
Pension value for lifetime allowance purposes = (£45,940 x 20) + £145,833 = £1,064,633.
So now Andrew’s pension value is below the lifetime allowance (£1,073,100) and he doesn’t face a lifetime allowance charge.
So, taking your pension early is definitely a tactic you can use to avoid the lifetime allowance charge BUT have you spotted the issue in this example?
By taking his pension early and avoiding the lifetime allowance charge Andrew has reduced his income in retirement from £51,624 (net of lifetime allowance charge) to £45,940. He’s given up £5,684 per year to avoid a £38,884 tax charge. Ultimately, he would have been better off from an income point of view paying the lifetime allowance tax charge.
Now you could say that Andrew will receive his pension 3 years earlier and that could factor into the mix but the point is, it’s not clear cut. You shouldn’t just aim to avoid the lifetime allowance charge for the sake of it. It needs careful consideration.
You wouldn’t turn down a pay rise at work just because you were going to pay tax on it would you?!
Other factors to think about when taking your pension early to avoid the lifetime allowance charge
If you were to take your pension early to avoid the lifetime allowance charge then you should also consider:
1. Retirement position. Do you actually plan to stop working at the point you take your pension income? If not then your pension income is going to be added to your salary and you could pay significantly more Income Tax.
2. Wide tax implications. Does taking the pension income early mean your total income is above £100,000 and therefore do you lose your personal allowance? Or over £50,000 and lose Child Benefit etc?
3. Dependents benefits. If you retire early and your pension income is reduced does that mean your dependents benefits are reduced too? Could your spouse or civil partner cope on the reduced income if you were to die first?
4. Death in service/ill health. If you were to leave work early it would probably mean giving up valuable death in service payouts. This could be useful especially if you were in poor health.
5. Lifetime allowance protections. Before taking any pension income ensure you have checked to see if you are eligible for any lifetime allowance protection as this could increase the lifetime allowance you are eligible for and potentially avoid the lifetime allowance charge.
As always, there is no one size fits all or rule of thumb. It’s not a given that you should always aim to avoid the lifetime allowance charge.
What matters is your plan for the future and how the resources you have are structured in a way that delivers you a sustainable income in retirement along with the ability to do all the things you want in life.
Need help? We are retirement planning specialists and have worked on hundreds of cases involving the lifetime allowance. Please contact us for a chat at our expense. We will help you understand your current position and what you need to do next.
Risk warning:
Stock market linked investments and any income from them, can fall as well as rise and is not guaranteed. Any figures quoted are for illustrative purposes and should not be taken as a forecast or guarantee. Past performance should not be seen as an indication of future returns and clients may get back less than they have invested.
