Maxxed-out pensions: what wealthy investors should do

By Faith Glasgow

Pension rules can be full of strange twists – and none stranger than the idea that, while we are all held responsible for financing our retirement, investors who make too good a job of it will be penalised.

But that is what the UK’s Lifetime Allowance (LTA) does, in effect: setting a maximum value that your pension pot can grow to without incurring a hefty tax penalty. At present, that threshold stands at £1,073,100, having been repeatedly fiddled with by successive chancellors.

Back in 2010, the LTA was increased to as much as £1.8mn, before being cut back to £1mn in 2016 and thereafter adjusted in line with inflation. However, in 2021, chancellor Rishi Sunak froze the allowance until April 2026 — which means investors are increasingly at risk of breaching the threshold in coming years. Recent figures show that, even before the LTA freeze, tax takings were on the rise: a record £283m was collected in LTA penalty taxes in 2018/19, up 6 per cent from the previous year.

Increasingly, those affected are not the super-rich but working people in generous workplace pension schemes. A 2019 (pre-Sunak freeze) report by Royal London estimated that up to 1.25mn people could breach the LTA by the time they retire – primarily well-paid company employees in workplace schemes and longstanding, relatively senior public sector workers on final salary pensions.

Jon Greer, head of retirement policy at Quilter, says that they could include people with pension pots now only half the value of the LTA with 15 or 20 years to go until retirement. He gives the example of someone with a pension of £555,300 growing at 5 per cent a year. Even without further contributions from employer or employee, the amount accumulated would breach the LTA in 20 years’ time (assuming increases in line with inflation after 2026). The same applies to an investor with ten years until retirement and a pension now worth £740,000.

So how is the allowance assessed and what do UK investors need to know about it?

The LTA test is applied by your pension provider every time you access your pension through a so-called benefit crystalisation event (BCE) — for example, by buying an annuity, moving funds into drawdown, or taking a tax-free lump sum.

Another LTA test occurs when you reach 75, this time also taking into account your remaining pension pot.

So, as Kate Smith, head of public affairs at Aegon, explained in a magazine interview last year: “Even though “Even though your withdrawals up to then may not have exceeded the LTA, if your remaining funds push you over the threshold at the age of 75 you’ll be liable for a tax charge on the excess.”

If you do breach the LTA threshold, the penalty is designed to claw back tax relief on those excess funds.

In the case of cash lump sums, the pension scheme administrator will hold back 55 per cent in tax for HM Revenue & Customs before handing over the balance, with no further tax payable. In the case of income taken via an annuity or drawdown, 25 per cent will be withheld by the administrator and you’ll then pay income tax as usual.

Although that sounds swingeing, it is because pensions are already an extremely tax-efficient environment, with overall returns boosted not only by upfront tax relief and your employer’s own contributions but also by the fact that no income or capital gains tax is payable on your investment pot as it grows.

Greer therefore cautions against allowing the tax-avoidance tail to wag the investment dog as, typically, it makes more financial sense just to shoulder the penalty. For example, defined benefit (DB) pension schemes are usually so generous that members are better off continuing to contribute and simply paying any LTA charge.

Moreover, says Greer: “If you are part of a defined contribution (DC) workplace pension scheme, it is more than likely that you should continue to accrue benefits within the scheme in order to benefit from the employer-matched contribution, even accounting for the LTA charge.” That’s because, even if you have to pay a 25 per cent LTA penalty, you’re effectively getting a 100 per cent return on your pension contribution, from your employer.

Also, if you are expecting to leave a potential inheritance tax bill, it may make sense to keep contributing to your pension. Pensions are outside your estate so they do not count towards inheritance tax, and the 25 per cent LTA charge is lower than a 40 per cent IHT bill.

But there are also several steps that can be considered if you are keen to reduce an LTA penalty, or avoid one altogether.

First of all, suggests Greer, UK investors could simply stop paying into a pension and contribute to an individual savings account (Isa) instead, if they have Isa allowances (up to £20,000 a year) remaining.

Another option is to redirect contributions into a spouse’s pension. “Of course, this is not risk-free, as it introduces the danger of divorce, but it does essentially double your lifetime allowance, given you can use your spouse’s allowance as well,” comments Greer.

Nigel Hatt, a pensions expert at wealth manager Tilney, says early retirement can work in your favour, as well. “If you start drawing benefits from an earlier age than you had anticipated, the fund value will be lower because fewer contributions have been paid into the pension,” he says. You may avoid breaching the LTA as a result.

Withdrawing the maximum tax-free lump sum from a pension pot — of up to 25 per cent — can also help, as it leaves less to continue growing, and less chance of breaching the LTA test at age 75. Against this, however, is the fact that the lump sum will count as part of your estate for inheritance tax purposes, whereas in your pension it does not.

Finally, it’s worth checking to see whether you can make use of the pension ‘protections’ put in place by the UK government. These were introduced in previous years when the LTA was reduced, allowing some people to keep the older, higher LTA threshold. For example, you can apply for ‘Fixed Protection 2016’ if you have not made any pension savings since 5 April 2016, and you will be granted an LTA of £1.25mn. Alternatively, if your pension savings were worth more than £1m on 5 April 2016 then, under ‘Individual Protection 2016’, you will get an LTA that is the lower of £1.25mn or the value of your pension rights at that point.

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