About Us Consumers Advisers Employers Media

You are not logged in.

• Log in
• Register

Adviser  >  Technical Central  >  Support material  >  Case Studies  >  Lifetime Allowance

Lifetime Allowance

The pension rules that came into effect on 6 April 2006 (A-Day) will have a profound impact on how your clients save for their retirement in the future. The importance of these changes cannot therefore be underestimated.

One of the main changes was the introduction of the lifetime allowance, which imposes a restriction on the size of pension funds that can be built up in a tax-advantaged environment. The limit was set at £1.5 million initially, and will increase to £1.8 million by 2010, with reviews every 5 years thereafter.  Different rules will apply to defined benefit pension arrangements - instead of a maximum fund to purchase a pension, the lifetime allowance is effectively applied as a maximum pension, calculated using a valuation factor of 20:1 (i.e. the maximum pension being a 20th of the lifetime allowance - £82,500 in the 2008/09 tax year).

Anyone who builds up pension benefits greater than the lifetime allowance will be subject to a lifetime allowance charge on the excess amount. Where the excess is taken as income it will be taxed at 25%, with the subsequent income then being subject to income tax. If the excess amount is taken as a lump sum a 55% tax charge will be imposed.

Clearly the lifetime allowance could have significant tax implications for your high net worth clients. However, it needn’t be a cause for sleepless nights, as the legislation includes transitional provisions to preserve benefits built up before A-Day. There are three ways in which your clients can choose to protect their pre A-Day benefits from the lifetime allowance charge, these are:

• primary protection
• enhanced protection
• both enhanced and primary protection

Primary protection

Primary protection is available to those individuals with total pension savings, including any benefits already being received, of more than £1.5 million at 5 April 2006. Under this option, the total value of all an individual’s pension funds as at the day before A-Day will need to be calculated. Pension benefits already in payment will be valued using a factor of 25:1, meaning that every £1,000 of pension being received at 5 April 2006 will count as £25,000 towards the lifetime allowance.

This value is then used to work out a ’primary protection factor’ which basically sets out how much more than the lifetime allowance the individual is entitled to. When benefits come into payment, the factor is applied to the lifetime allowance in force at that time to work out how much more than the lifetime allowance the individual is entitled to at that point. Any amounts over and above the lifetime allowance increased by the primary protection factor will be subject to the lifetime allowance charge.

Where primary protection has been selected, any tax-free lump sum entitlement of more than 25% of the lifetime allowance at A-Day (£375,000) will also increase in line with increases to the standard lifetime allowance.

Enhanced protection

Enhanced protection can be used by individuals who want full protection from the lifetime allowance charge. This option allows individuals to take their full A-Day pension benefits at retirement, including any investment growth post A-Day, without incurring a lifetime allowance charge.

There is no minimum fund to register for enhanced protection, however anyone selecting this option must not be an active member of a pension scheme from A-Day and/or cannot build up any further benefits. This means no further contributions can be made to any money purchase pension plans held, and no increases to benefits above certain limits are allowed in final salary and cash balance schemes. The exception is rebate payments from S2P, which will be permitted provided the receiving plan was contracted-out prior to A-Day.

Where enhanced protection has been selected, and an individual had a right to a pre A-Day tax-free lump sum amount of more than 25% of the lifetime allowance at A-Day, this entitlement will be retained as a percentage of their pension fund. For example, if an individual was entitled to 27% of their pension fund as a lump sum at A-Day, they will be eligible to receive a tax-free lump sum of up to 27% of their pension benefits when they take their benefits, regardless of the size of the pension fund at that time.
 
If the member had a pre A-Day tax-free lump sum amount of more than 25% of their benefits value but less than 25% of the lifetime allowance at A-Day they are not eligible to apply for enhanced protection of the lump sum benefit. However the pre A-Day value of the tax-free lump sum will be increased in line with increases to the standard lifetime allowance.

Clients have until 5 April 2009 to register their pre-A-Day benefits with HM Revenue & Customs, using form APSS 200, available at www.hmrc.gov.uk/pensionschemes/protection.htm. However clients seeking enhanced protection must already have ceased making pension contributions, or accruing relevant benefits in excess of certain limits, prior to A-Day.

Example
Let’s look at an example of how the lifetime allowance and transitional protection works in practice.

Mr Smith is a director of an engineering firm and has an executive pension plan. Mr Smith ceased full time work on December 2005, and stopped paying contributions at that time. He does not however intend taking benefits until March 2009.

On 5 April 2006 Mr Smith’s pension fund was worth £1.6 million and he had an entitlement to a tax-free lump sum of £480,000. It is anticipated that when he retires his total fund value will have increased to £1.8 million, £150,000 more than the £1.65 million lifetime allowance that will apply at that time.

So what should Mr Smith do? He has four options:

• do nothing
• choose primary protection
• choose enhanced protection or
• choose both primary and enhanced protection together.

Option 1
If Mr Smith does not register his pre A-Day pension fund with HM Revenue & Customs (HMRC) any pension benefits at retirement in excess of the lifetime allowance will be subject to the lifetime allowance charge.

In this situation, Mr Smith will be entitled to a tax-free lump sum of £528,000 (£480,000 increased in line with increases to the standard lifetime allowance) and income from the remaining balance of £1,122,000. The remaining excess amount of £150,000 can be taken as a lump sum or income but will be subject to the lifetime allowance charge.

• Tax-free lump sum: £528,000 (£480,000 increased in line with increases to the LA = £1,650,000/£1,500,000 = 1.1; 1.1 x £480,000 = £528,000)
• Fund to provide an income: £1,122,000 (£1,650,000 - £528,000)
• Fund subject to lifetime allowance charge:
  £150,000 (£1,800,000 - £1,650,000)

This option is clearly unsatisfactory, as Mr Smith will be hit with a substantial tax charge of up to £82,500, if the excess is taken as a lump sum (55% of £150,000).

This situation could be avoided, however, if Mr Smith decides to protect his pre A-Day benefits by registering for primary or enhanced protection. But which option should he choose?

Option 2
If Mr Smith opts for primary protection he can register his 5 April 2006 fund value of £1.6 million and set his own ‘primary protection factor’ which is calculated by the formula: 

(1,600,000 - 1,500,000)/1,500,000 = 0.07

When he retires in 2009, his primary protection factor will be used to calculate his individual lifetime allowance – i.e. £1,650,000 + (£1,650,000 x 0.07) = £1,765,500. His maximum tax-free lump sum will increase in line with increases to the standard lifetime allowance, rising to £528,000.

In this scenario, Mr Smith will receive £528,000 as a tax-free lump sum and an income from the remainder of his individual lifetime allowance. The part of the fund in excess of the individual lifetime allowance can be taken as a lump sum or income
but will be subject to the lifetime allowance charge.

• tax-free lump sum: £528,000 (£480,000 increased in line with increases to the SLA)
• fund to provide an income: £1,237,500 (£1,765,500 - £528,000)
• fund subject to lifetime allowance charge: £34,500 (£1,800,000 - £1,765,500).

Option 3
As an alternative to primary protection, Mr Smith could opt to register for enhanced protection. This will eliminate the lifetime allowance charge and safeguard the percentage of the final fund available as a tax-free lump sum. It is important to note however that Mr Smith can only do this because he has already stopped paying contributions.

On 5 April 2006 Mr Smith’s tax-free lump sum entitlement was 30% of the pension fund (£480,000 / £1,600,000 x 100% = 30%) and more than 25% of the lifetime allowance at A-Day. This is retained post A-Day, giving a maximum lump sum of 30% of the total fund value at retirement. The remaining fund is used to provide an income.

• tax-free lump sum: £540,000 (30% of £1,800,000)
• fund to provide an income: £1,260,000 (£1,800,000 - £540,000) 
  

Option 4

If Mr Smith only registers for primary protection he is not able to change his mind at a later date and opt for enhanced protection. However, if he registers for both primary and enhanced protection and decides post A-Day that he would like to restart contributions he is permitted to do so, provided that the HMRC is informed (a fine of £3,000 may apply otherwise). He loses his enhanced protection and will be treated as having only selected primary protection at A-Day.

If Mr Smith decides in December 2008 that he would rather maximise his total pension benefits than safeguard his tax-free lump sum entitlement, he can restart contributions into his plan. By making additional contributions to his plan, Mr Smith increases his final fund value to £1.85 million. In this situation, Mr Smith will receive the following:

• tax-free lump sum: £528,000 (£480,000 increased in line with increases to the SLA)
• fund to provide an income: £1,237,500 (£1,765,500 - £528,000)
• fund subject to lifetime allowance charge:
  £84,500 (£1,850,000 - £1,765,500).

In this example, primary protection minimises the amount of Mr Smith's total fund which will be subject to the lifetime allowance charge whereas enhanced protection gives the best tax-free lump sum.

How will this affect advice?

All clients who had funds close to or in excess of the lifetime allowance of £1.5 million on 5 April 2006 and those who are entitled to a tax-free lump sum of more than 25% of their pension fund, or 25% of the lifetime allowance (£375,000), should be identified in your records.

If you haven’t already done so, you should consider contacting them to arrange a meeting to explain how the legislation will affect them and whether protection is required.

If the client applies for protection this will also affect future planning, for example clients with enhanced protection will lose this if they make any future pension contributions.

Care must also be taken where clients are considering switching to a new pension plan, as some existing entitlements (e.g. a tax-free lump sum of more than 25% of the pension fund) could be lost on transfer. Clients who are divorcing should also be aware as they may lose their primary protection if they pass some benefits to their ex-spouse.

This case study is an example only, and while it highlights some of the opportunities for planning, it should be recognised that it is not a complete or exhaustive description of the opportunities or pitfalls.

The details shown are based on our understanding of current taxation law and practice, the Finance Act 2004 and the Finance Act 2005. These may be affected by future changes in legislation and the individual circumstances of the investor.

Published 18 April 2008