Written by Tom Selby, head of retirement policy at AJ Bell
After over a decade of persistent cuts to pension tax relief, Jeremy Hunt yesterday reversed that trend by providing a massive boost to savers.
The decision to scrap the lifetime allowance is monumental, ridding the pensions system of one of its biggest sources of complexity and massively raising the attractiveness of retirement saving.
As a result, someone contributing £60,000 a year for 30 years could build a retirement pot worth £3.5 million, with only income tax to pay on withdrawals above the tax-free cash entitlement. Pensions can also be passed on extremely tax efficiently on death.
The money purchase annual allowance (MPAA), which applies to those who flexibly access their private pension post-55, is currently set at such a low level it risks acting as a disincentive to work. It also felt like an overly severe punishment for people who might have accessed their retirement pot during a time of severe financial strain and planned to rebuild their savings afterwards.
In that context, raising the MPAA back to £10,000 – the level it was originally introduced at in 2015 – feels like a sensible, pragmatic step.
The tapered annual allowance, which applies to higher earners, remains an unwelcome area of complexity and ideally would be abolished altogether. However, yesterday’s announcement at least means it should apply to fewer people and have a less significant impact.
*Assumes 4% per annum investment growth after charges
How yesterday’s big pension changes will impact savers and retirees
- Scrapping the lifetime allowance
Defined contribution schemes
The lifetime allowance currently caps the total amount you can save in a pension without having to pay an additional tax charge at £1,073,100. The amount of tax-free cash you can receive over your lifetime is also limited to 25% of your lifetime allowance (i.e. £268,275).
If you breach your lifetime allowance, a charge will be applied to the excess. This charge will be 25% if the money is left in the pension or 55% if taken out of the pension.
Scrapping the lifetime allowance gives pension savers of all ages more flexibility to build their retirement funds and reap the rewards of taking investment risk.
The below examples are for illustrative purposes only. The first two assume the current £1,073,100 lifetime allowance rises each year in line with inflation.
Example 1: The young striver
Emma, 21, begins her career on a salary of £30,000. She immediately joins the company pension scheme where her employer pays 8%, and she pays the maximum contributions of 8%, with a further 2% coming from basic rate pension tax relief.
Emma enjoys 4% inflation-adjusted wage growth each year and 4% inflation-adjusted investment returns. Assuming she keeps contributing 18% in total to her pension each year, Emma could hit the £1,073,100 lifetime allowance just after her 60th birthday.
With the lifetime allowance removed, she could keep contributing and enjoying investment growth without having to worry about paying a lifetime allowance charge when she comes to access her fund.
Example 2: The middle-aged squirreller
Colin, 45, has saved diligently and as a result has built a pension pot worth £400,000. He earns £60,000 a year and pays 4% of his salary into his company pension. This benefits from 1% upfront tax relief and a ‘double-match’ from his employer worth 8%, taking his total contribution to 13%.
Colin’s salary grows by 2% above inflation each year and his investments deliver 4% inflation-adjusted growth. Assuming he keeps contributing 13% in total into his pension each year, Colin could reach the £1,073,100 lifetime allowance just after his 62nd birthday.
As in the case of Emma, with the lifetime allowance removed, Colin could keep contributing and enjoying investment growth without having to worry about paying a lifetime allowance charge when he comes to access his fund.
Example 3: The retiring risk-taker
Howard is approaching his 75th birthday. He ‘crystallised’ his entire £1 million pension pot in the 2016/17 tax year, taking £250,000 tax-free cash and putting the remaining £750,000 into drawdown. As the lifetime allowance was exactly £1 million in 2016/17, this used up his entire lifetime allowance.
However, Howard chose not to touch the drawdown fund and instead kept it invested. His investments delivered big returns and the drawdown fund enjoyed growth of 10% per year, after charges. As a result, by age 75 – when HMRC currently demands the investment growth is ‘tested’ against the lifetime allowance – Howard’s drawdown fund has grown to around £1,461,000.
With a lifetime allowance of £1,073,100, the excess of £388,000 would be subject to a lifetime allowance charge. As the excess is taken as income there will be a charge of 25% (£96,975), with income tax to pay on top of that.
With the lifetime allowance charge removed, Howard would only have to pay income tax on withdrawals above his tax-free cash limit.
Defined benefit schemes
For savers in a defined benefit (DB) scheme, a calculation is made to determine how much lifetime allowance you have used. Broadly speaking, this involves multiplying your annual income entitlement by 20, then adding on any tax-free cash entitlement you have.
With a £1,073,100 lifetime allowance, the maximum income someone in a DB scheme could build up without paying a lifetime allowance charge is £53,655.
The removal of the lifetime allowance means DB pension scheme members will no longer face a lifetime allowance charge.
- Increasing the annual allowance from £40,000 to £60,000
Defined contribution schemes
The annual allowance limits the total amount you can contribute to a pension without paying a tax charge. This covers personal contributions, employer contributions and tax relief. Your personal contributions are limited to 100% of your earnings.
It is also possible to ‘carry forward’ unused annual allowances from the three previous tax years.
If you breach your annual allowance, you will face an annual allowance charge designed to remove the upfront tax relief your contribution would have received.
Broadly, that means a basic-rate taxpayer would pay a 20% charge, a higher-rate taxpayer 40% and an additional-rate taxpayer 45%. For example, if a 40% taxpayer exceeded their annual allowance by £1,000, they would pay a tax charge of £4,000 (40% x £1,000).
Yesterday’s changes mean someone in a DC scheme can contribute £20,000 a year more to their pension each year without paying a tax charge. The maximum someone in a DC scheme can carry forward will also rise in future years in line with the increase in the annual allowance. By the 2026/27 tax year people will be able to carry forward up to £180,000.
Defined benefit schemes
Because DB members build up an entitlement to a promised income, the annual allowance is calculated based on the capital value of the increase in pension benefits each year. This involves calculating an ‘opening value’, adjusted for inflation, multiplied by a factor of 16 plus any separate lump sum entitlement, and a ‘closing value’ for their benefits (again multiplied by 16 plus any separate lump sum entitlement), and then subtracting the former from the latter.
- Increasing the money purchase annual allowance from £4,000 to £10,000
The money purchase annual allowance applies to anyone who has ‘flexibly accessed’ taxable income from their DC pension. Once triggered, it reduces your annual allowance and removes the ability to ‘carry forward’ unused annual allowances from the three previous tax years.
Previously, the MPAA was set at £4,000. However, yesterday’s announcement increases that figure to £10,000 – the amount it was originally set at in 2015.
The term ‘flexibly access’ mainly refers to taking income via drawdown, where your pension is invested and you take an income to suit your needs, or ad-hoc lump sums direct from your DC pot. Taking an income in DB or buying a lifetime annuity won’t trigger the MPAA.
If you breach your annual allowance, you will face an annual allowance charge designed to remove the upfront tax relief your contribution would have received.
Broadly, that means a basic-rate taxpayer would pay a 20% charge, a higher-rate taxpayer 40% and an additional-rate taxpayer 45%.
There are a few other ways to access taxable income from your pension without triggering the MPAA:
- Just take your tax-free cash. While accessing taxable income flexibly from your pension will trigger the MPAA, withdrawing your tax-free cash won’t. It is possible to ‘partially crystallise’ your fund so you just take out the tax-free cash you need, with the rest left in your drawdown fund and able to grow tax-efficiently.
- Take a small pot withdrawal. If your fund is worth £10,000 or less you can withdraw both the tax-free and taxable element flexibly without triggering the MPAA. You must extinguish the entire fund in order not to trigger the MPAA. You can take up to three small pot withdrawals worth £10,000 or less from personal pensions in your lifetime and an unlimited amount from workplace pensions.
- Capped drawdown. Capped drawdown is no longer available, but some savers who were in capped drawdown before April 2015 have remained in it. Provided any withdrawals taken via capped drawdown do not exceed the maximum income limit (150% of the GAD annuity rate), the MPAA will not be triggered.
- Increasing the tapered annual allowance from £4,000 to £10,000
The tapered annual allowance is currently triggered where someone has:
- ‘threshold’ income above £200,000
- ‘adjusted’ income above £240,000
For every £2 of adjusted income above £240,000, the annual allowance of high-income savers reduces by £1, to a minimum of £4,000 for those with adjusted income of £312,000 or more.
yesterday’s decision to increase the adjusted income threshold to £260,000 and the minimum tapered annual allowance to £10,000 should mean fewer high earners are caught by the taper and the impact should be lower.
