![What is the lifetime allowance?](/https/www.telegraph.co.uk/content/dam/pensions-retirement/2023/03/14/TELEMMGLPICT000328939248_trans_NvBQzQNjv4BqqVzuuqpFlyLIwiB6NTmJwfSVWeZ_vEN7c6bHu2jJnT8.jpeg?imwidth=680)
What is the lifetime allowance, exactly?
Deciding to scrap the allowance altogether, is a major win for pension savers
![What is the lifetime allowance?](/https/www.telegraph.co.uk/content/dam/pensions-retirement/2023/03/14/TELEMMGLPICT000328939248_trans_NvBQzQNjv4BqqVzuuqpFlyLIwiB6NTmJwfSVWeZ_vEN7c6bHu2jJnT8.jpeg?imwidth=680)
Pensions are a fantastic way of saving because any money invested is spared income tax, meaning your returns are effectively boosted by up to 45pc immediately.
However, pension savings were only tax-free to a point. The “lifetime allowance” kicked in at £1.073m and could put a serious dampener on your retirement savings.
However, Chancellor Jeremey Hunt committed to scrapping the lifetime allowance in his Spring Budget.
The allowance was previously frozen until 2028, and the Chancellor had been expected to raise it in an effort to get over 50s back to work.
Deciding to scrap the allowance altogether, is a major win for pension savers. After all, it is the tax relief that makes pensions so attractive – any investment returns made in your fund are also free of capital gains tax and dividend tax.
You usually only pay tax on your pension when you start withdrawing an income from it in retirement. This method of tax is known as “EET” – it means that contributions are exempt from tax on the way in, exempt from tax when they are growing, and then taxed when taken out as income.
The lifetime allowance put a ceiling on how much you can benefit from these tax perks, now the contributions are only restricted by the annual allowance which is to be raised from £40,000 to £60,000. Here, Telegraph Money explains how the lifetime allowance works.
How big can my pension pot be before I start paying tax?
The lifetime allowance is the amount that someone can save in total for their private pension without incurring a tax charge. It has been frozen at £1.073m since the 2020/21 tax year, and has almost halved, in nominal terms alone, over the past 11 years.
The tax charge will now be removed starting from April 2023, and abolished entirely from April 2024.
The deep freeze had meant that more and more pensioners were at risk of breaking the rule. Any savings over the limit are taxed at 55 per cent if the money is taken as a lump sum, or at 25 per cent plus your income tax rate if taken out gradually.
It means that if someone were to withdraw £100,000 of savings above the threshold at once, it would trigger a £55,000 tax bill.
When it was introduced in 2006, the allowance was £1.5m. It was raised to £1.8m in 2010, cut to £1.5m, then down to £1.25m and eventually to £1m in 2016. It rose with inflation until 2021 when it was frozen by then chancellor Rishi Sunak at its current level for five years.
More than 8,000 breached the cap in the 2020-21 tax year, paying around £382m, according to the latest data from HM Revenue & Customs.
When does it apply?
There are checks at certain times over the course of your retirement to see if your pension has exceeded the lifetime allowance. You might have to pay a tax charge if it has.
These checks usually happen when or if:
- you draw money from a defined benefit pension
- you take an income or lump sum from a defined contribution pension
- you transfer a pension overseas before the age of 75
- you have reached your 75th birthday and have a pension in drawdown or one that you have not yet accessed
Untouched pension pots that exceed the lifetime allowance are taxed at 25 per cent above the threshold on the saver’s 75th birthday.
Will the lifetime allowance affect me?
This depends on how much you earn, how much you save into your pension, and what type of scheme you are enrolled in.
Most people are enrolled into a “defined contribution” pension, which invests your savings over the course of your career. You then withdraw money from this pot as income when you retire.
If this is the type of scheme that you are enrolled in, then the calculator below will give you a good estimate of whether you would have breached the lifetime allowance.
It is understood that the breaching the lifetime allowance will not incur a tax charge from April, but the Treasury has not confirmed anything further.
Lifetime allowance calculator
You must estimate what your pension will look like when the checks are carried out. For example, if you are 55 now and do not expect to take out any money from your pension until you are 67, then you must consider how your fund might fluctuate in value over the next 12 years.
If you are in a defined benefit pension scheme, then a good rule of thumb to calculate your fund’s value is to multiply your expected retirement income by 20. You will then need to add the amount of any separate tax-free cash lump sum you wish to take.
Remember, no matter what type of scheme you are enrolled in, cashing out your lump sum will not stop your pension from hitting the lifetime allowance. This is because everything you take from your pension is calculated together to show how much of the lifetime allowance you have used.
Why could the lifetime allowance have been increased?
Chancellor Jeremy Hunt was thought to have been considering increasing the lifetime allowance, to as high as £1.8m in the Spring Budget. It was last this high in 2011. Instead, he scrapped it.
The allowance had shrunk to £1m in 2016, and then rose with inflation until 2021, when it was frozen by Rishi Sunak as chancellor. It meant that workers have been able to save less into their retirement fund, while the cost of living has gone up.
A higher lifetime allowance would have fit into Mr Hunt’s campaign to get people aged over 50 back into the workforce, as thousands take early retirement for fear of breaching the lifetime allowance limit.
![Prime Minister Rishi Sunak speaks with Chancellor the Exchequer Jeremy Hunt](/https/www.telegraph.co.uk/content/dam/pensions-retirement/2023/03/13/TELEMMGLPICT000328075112_trans_NvBQzQNjv4BqFOgdDOZBSSpUpWf9Rnp5s6Aezwuvexs_ues-aCB_TCg.jpeg?imwidth=350)
Did the lifetime allowance affect everyone?
The lifetime allowance did not affect everyone, as most people do not have a pension large enough to be in danger of breaching the limit.
The rule also does not impact all workers in the same way. It has historically been more likely to hit people with defined contribution pensions, as opposed to defined benefit pensions. These are rare in the private sector, and much more common in the public sector.
For savers in defined contribution pensions, the limit applies to the value of their invested pot. However, for members of public sector schemes, this value is typically calculated by multiplying their expected annual pension by 20.
It means that a retired public sector worker can have a retirement income of £53,655 without hitting the cap, while a private sector worker with a pension at the cap would have received an income of just £44,208 if they bought an annuity at the start of 2022. Above that level, they would be taxed at a rate of up to 55 per cent.
Annuity rates have improved since, but it shows that defined contribution pension savers are much more vulnerable to market fluctuations than retired public sector workers.
Can I reduce my lifetime allowance tax bill?
It was possible in some cases to cut your tax bill if you breached the lifetime allowance. The limit has been chopped and changed so many times that HM Revenue and Customs introduced some protections, which allow savers who are close to, or have just hit the lower limit, to apply for an exemption.
Anyone with pension savings over £1m as of April 2016, when the cap was cut from £1.25m, can apply for one of two protections.
The first is the “individual protection 2016”, which keeps the lifetime allowance at the lower of either £1.25m or the value of your pension savings on April 5 2016. You can continue to save into your pension but you have to pay tax on any withdrawals beyond this protected threshold.
The second is “fixed protection 2016”, which fixes the allowance at £1.25m, but you have to opt out of any auto-enrolment and not make any more payments into your scheme. If you do, you will lose the protection and revert to the current standard lifetime allowance.
This may not work in favour of workers who are enrolled in a defined benefit pension scheme, so make sure you discuss this with an adviser before you apply for this protection.