I’d appreciate it if you could explain how the assessment of pension funds against the lifetime allowance/fixed protection amount works at age 75. In particular are pension commencement lump sums added back to the scheme values?

Stephen

Tom Selby, AJ Bell Senior Analyst says:

The lifetime allowance is a cap on the amount someone can save in a UK pension before a tax charge might apply. Where someone exceeds the lifetime allowance, HMRC will levy a charge on the excess to remove some of the tax advantages that individual has enjoyed.

The current UK lifetime allowance is £1,073,100. Chancellor Rishi Sunak announced in the March 2021 Budget that this figure will remain frozen until the endof the current Parliament(i.e. tax year 2025/26).

The lifetime allowance has been changed various times since 2006, creating several ‘protection’ regimes designed to ensure people close to or over the previous limits were not unfairly penalised. These protections allowed savers to lock-in a higher lifetime allowance – although terms and conditions applied when doing this.

You can read more about how these lifetime allowance protections work here and here. 

If you have one of the three versions of fixed protection, provided you don’t breach the terms of that protection you’ll have a pensions lifetime allowance of:

• £1.8 million (Fixed protection 2012)

•£1.5 million (Fixed protection 2014)

• £1.25 million (Fixed protection 2016)

Tax-free cash (also sometimes officially known as ‘pension commencement lump sum’ or PCLS) is capped at a quarter of your available lifetime allowance, with any further withdrawals taxed in the same way as income.

For example, someone with a £1.8 million lifetime allowance could take up to £450,000 tax-free.

The amount of lifetime allowance someone has used will be ‘tested’ when a ‘benefit crystallisation event’ occurs. These benefit crystallisation events include taking your tax-free cash and choosing a retirement income route (such as annuity or drawdown). A lifetime allowance test will also be carried out on your 75th birthday.

For any pensions you haven’t accessed by age 75, this test will simply compare the total amount in your pot to your available lifetime allowance.

If you are in drawdown, HMRC your provider will compare the size of your fund at age 75 to the size when you first entered drawdown (after tax free cash was taken). If your fund is worth more now, this growth will also be tested against the lifetime allowance.

If you have not used your full tax-free cash entitlements by age 75, these will simply be included in the overall size of your fund when the age 75 lifetime allowance test occurs.

For those in defined benefit (DB) schemes, the age 75 test shouldn’t be relevant as an income is usually secured by this age.

Where a DB pension is tested against the lifetime allowance, the annual income due at age 75 is multiplied by 20 and then compared to the available allowance.

For example, if someone is entitled to a DB pension worth £20,000 a year, for the purposes of the lifetime allowance this would be valued at £400,000 (£20,000 x 20).

Where a tax-free lump sum is taken, this will be added to the overall fund value and tested against the lifetime allowance, assuming the tax-free cash accrues separately.

If this sum is paid through commuting or giving up part of a pension for cash then the allowance is tested against the full pension before any commutation multiplied by two.

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Please note, we only provide information and we do not provide financial advice. If you’re unsure please consult a suitably qualified financial adviser. We cannot comment on individual investment portfolios.

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