Are middle class savers getting stung by a 55% pension trap meant for millionaires?

Lifetime Allowance GuidanceThe article below from This is Money provides a very startling view of how some savers could get caught out by a tax penalty they never thought would be aimed at them.

  • The maximum you can build up in a pension without a tax penalty is £1.03m
  • But many workers whose salaries have risen unwittingly breach this allowance
  • The result is a £70m jump in pension tax collected by HM Revenue & Customs 

A £1 million pension pot might sound like a luxury reserved for the super-rich. After all, the absolute maximum the Government allows you to build up in a pension is £1.03 million.

Anything above this is taxed at 55 per cent when you take it out.

But research for Money Mail has found many workers whose salaries have risen to about £80,000 are unwittingly breaching this so-called lifetime allowance.

The result is a £70 million jump in pension tax collected by HM Revenue & Customs over the past two years — and the numbers of people caught out is doubling.

Experts estimate as many as 500,000 savers could be at risk of falling foul of the lifetime allowance trap.

Those affected include head teachers, middle managers, accountants and public sector workers with final-salary pensions.

With this scheme, your retirement income is based on your final salary and your years of membership — not a pot of cash you’ve set aside.

To work out how much these guaranteed retirement incomes are worth against the £1.03 million lifetime allowance, the taxman multiplies your starting retirement income by 20.

So if you were on track to earn £10,000 a year when you retired, your pot would be deemed to be worth £200,000.

Calculations by investment firm AJ Bell show it’s easier to breach the £1.03 million allowance than it might seem. Most final salary schemes have an accrual rate of 1/60. This means that for each year of service, you build up a pension worth 1/60 of your final salary.

Say a teacher started out at age 25 and worked for 40 years, retiring at 65 as a headteacher on a £90,000 salary. They would have built up a pension worth 40/60 of that final £90,000 salary — or £60,000 a year.

HMRC would multiply that figure by 20 to see how it compares to the lifetime allowance. This works out at £1.2 million. The headteacher would face a tax charge on the sum above £1.03million — £170,000.

This is subject to a 55 per cent charge if taken as a lump sum. If it’s left in the pension and taken as annual income, the rate is 25 per cent on top of any normal income tax charges.

In the case of the headteacher, the extra tax charge would be £93,500 if taken as a lump sum or £42,500 if taken as regular income. If you choose the income option, you must still pay the tax charge up front.

Those earning under £80,000 can breach the limit if they have private pension savings as well as final-salary arrangements.

For example, a middle manager earning £70,000 with 40 years of service would be on track for a final-salary pension worth about £933,333 in total.

If that worker also saved £250 a month into a private pension, they would have £104,158 after 20 years, assuming 5 per cent investment growth after charges.

This would tip them over the lifetime allowance by £7,491 attracting a £4,120 tax charge if taken as a lump sum.

Those who change career could also be affected. Imagine someone who changes job aged 50, having reached a £70,000 salary after 30 years.

They might be on track for an annual final-salary pension of £35,000 — worth £700,000 in the taxman’s eyes.

If that person earned £70,000 for another 20 years — their remaining working life — and started paying 17 per cent of their salary into the pension scheme at their new employer, they would only need an annual 5 per cent return to bust the lifetime allowance at age 64.

Their fund value would then be £1,039,862 — just over the £1.03 million limit.

If they dipped into the fund at that point, there would be a £5,424 tax charge if taken as a lump sum.

And future growth above this level is sure to create a rising liability for tax. The lifetime allowance was introduced in 2006 at £1.5 million to stop high earners using pensions to dodge income tax.

The threshold has fallen steadily over recent years, meaning more and more people are getting caught out.

How has lifetime allowance threshold changed over the years?

Lifetime Allowance change over the years

Tax charges for breaching the lifetime allowance more than tripled from £40 million in 2014-15 to £110 million in 2016-17. The numbers ensnared more than doubled, from 1,020 to 2,410.

Tom Selby, senior analyst at AJ Bell, says: ‘The reality is many workers with final-salary schemes have no idea their pension is worth anywhere near £1 million, so there is a risk they will be caught out and face a whopping tax charge.’

There are ways of protecting yourself. In 2016, HMRC introduced schemes to protect some investors’ allowances, known as Individual Protection 2016 and Fixed Protection 2016. There is no application deadline.

Individual Protection 2016 allows someone with a pension worth more than £1 million at April 5, 2016, to shield their pot from tax charges, subject to a maximum £1.25 million. You can continue saving into a pension if you have allowance left.

With Fixed Protection 2016, your lifetime allowance is frozen at £1.25 million. Anyone can apply, but you cannot make any more contributions.

You can use Fixed Individual Protection 2016 and Individual Protection 2016 at the same time. About 61,000 people registered individual protection on pension funds in 2016-17, up from 6,000 the year before, and 21,000 in 2014-15.

Patrick Connolly, a certified financial planner at Chase de Vere, says: ‘While paying a tax charge is far from ideal, what matters is the amount of pension you actually receive.

It may be better to benefit from employer contributions and achieve, say, a £1.5 million pension pot and pay the extra tax.

‘It depends on your situation, so independent financial advice is important.’

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