Pensions - What is the Lifetime Allowance?

What is the Lifetime Allowance?

Pensions in the UK get generous tax reliefs, but there are some limitations. The Lifetime Allowance is the maximum value of benefits which can be taken from registered pension schemes without incurring a special tax charge – known as the lifetime allowance tax charge. 

The Lifetime Allowance

The standard Lifetime Allowance (LTA) is currently £1m. However it has changed frequently since it was introduced in 2006 as shown below. The intention is it will increase in line with the Consumer Prices Index from 2018 onwards.

Protection

When the LTA was introduced in 2006 the Government allowed people to apply for two types of protection – known as primary and enhanced protection – to enable people to protect their pension fund from the lifetime allowance charge. Further types of protection have been introduced as the LTA was reduced in 2012, 2014 and 2016. In essence, protection gives a member an entitlement to a special personal lifetime allowance and means a member will pay no, or a lower, lifetime allowance tax charge than if they used the standard LTA. 

Benefit Crystallisation Events

A test is carried out each time benefits are taken from a registered pension scheme to check if the LTA has been exceeded – these are known as Benefit Crystallisation events (BCEs) and there are 13 of them.

BCE What and when Amount measured against LTA
1 Individual moves funds to provide a drawdown pension The value of the amount moved into drawdown
2 Individual becomes entitled to a scheme pension before age 75 20 times the pension paid in the first year.
3 An increase in a scheme pension exceeds a certain level

20 times the excess pension increase

4 Individual becomes entitled to a lifetime annuity The value used to buy the annuity (less any amounts previously crystallised under BCE1 if funds are coming from a drawdown arrangement)
5 An individual reaches age 75 and has not taken all of their benefits under a defined benefit scheme 20 times the pension, plus any separate lump sum, as if these benefits were taken at age 75
5a An individual with drawdown pension funds reaches age 75 The value of the drawdown less any amounts previously crystallised under BCE1
5b An individual reaches age 75 with uncrystallised funds in a money purchase arrangement The value of the uncrystallised funds
5c An individual dies before age 75 and remaining uncrystallised funds are designated for dependant’s or nominee’s flexi-access drawdown* The value of the amount moved into drawdown
5d An individual dies before age 75 and remaining uncrystallised funds are used to buy a dependant’s or nominee’s annuity* The value used to buy the annuity
6 Payment of a relevant lump sum before age 75 (eg tax-free lump sum) The amount of the lump sum
7 Payment of a lump sum death benefit where individual dies before age 75 The amount of the death benefit
8 Transfer to a Qualifying Recognised Overseas Pension Scheme (QROPS) The amount transferred (less any amounts previously crystallised under BCE1 if funds are coming from a drawdown arrangement)
9 Any other event prescribed in regulations. Currently includes certain payments made (arrears after death, pension errors) Depends on event

*Needs to be within 2 years of Scheme Administrator being informed of death

Example BCE

Meredith gets to age 65 with a pension pot of £200,000 and the LTA is £1m. She decides to take her maximum tax-free lump and use the rest to buy a lifetime annuity.

An LTA check is triggered. There are two BCEs. £50,000 falls under BCE6 (the payment of a lump sum) and £150,000 falls under BCE4 (entitlement to a lifetime annuity).

Meredith has used up 20% of the LTA {(£50,000+£150,000)/£1m}.

Taking benefits at different times

The position is more complicated where people take benefits in different tax years when the LTA is different. Each time a BCE occurs, some of the individual’s lifetime allowance is used up, leaving less lifetime allowance available for use in the future. Each BCE is measured as a percentage of the LTA in that year.

Example

Mike crystallises his benefits in October 2006 with a capital value of £150,000. The LTA at that time is £1.5m. The percentage of the LTA used is 10%. So Mike has 90% of his LTA still available.

In December 2010, Mike crystallises a further £450,000 when the LTA is £1.8m. So Mike has used up a further 25% of the LTA.

In total he has used up 35% of his LTA.

The special tax charge

If the value of benefits exceeds 100% of the LTA, a lifetime allowance tax charge will be payable on the excess. This is currently 55% if the excess is taken as a lump sum. If the excess remains in the pension wrapper, an immediate tax charge of 25% is due and normal rules apply to any future pension withdrawals which are taxed as income under the Pay As You Earn system. 

Age 75

If an individual doesn’t take their benefits until after age 75, then all uncrystallised funds are tested under BCE5b at age 75. When the individual takes their pension benefits in future (eg at age 80) there is no further check against the lifetime allowance. 

Second check

If a BCE occurs and the funds in question have already been the subject of an LTA check, the amount crystallised at outset are taken into account. This concept prevents ‘double-counting’ and only any growth is measured against the LTA on the second check. 

Drawdown funds are subject to a further check at age 75 (BCE5a) which calculates the growth in the value of the benefits between entering drawdown and age 75. This growth will then be measured against the LTA. 

If an individual had initially used drawdown then decided to use some of those funds to purchase a lifetime annuity at a later date, the value measured against BCE4 is the amount used to buy the annuity less any amounts previously crystallised under BCE1. 

Example BCE

Brian had a fund of £800,000 when he took benefits in 2007. At that point the LTA was £1.6m. He decides to take his maximum tax-free lump sum and put the remaining funds into drawdown. The £200,000 lump sum is valued using BCE6, and the £600,000 designated for drawdown using BCE1. Brian uses up 50% of his LTA. 

In 2011 Brian decides to use his full drawdown pot, which has grown to £750,000, to buy a lifetime annuity. The LTA at this point is £1.8m.

The value measured against his LTA under BCE4 (entitlement to a lifetime annuity) is £750,000 less the amount previously crystallised when he entered drawdown (£600,000) which equals £150,000. This is measured against Brian’s LTA and uses up another 8.33%. Brian has used up 58.33% of his LTA.

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