What is the Lifetime Allowance (LTA)?
The LTA puts a cap on our total tax-relieved pension pot – currently £1,073,100 – and breaching it will result in a tax cost. Once funds are in a pension scheme, you have little control over the growth and, with the news that the LTA will be frozen until 2026, it’s an issue more of us will need to grapple with.
Should you stop contributing to your pension when you reach the limit?
Not necessarily. It’s widely believed that you should stop pension contributions rather than go over the LTA, but it isn’t always the smart answer. You’ll start to feel better about the LTA if you think of it as just another allowance, rather than a punishment. It isn’t your fault if your fund grows beyond the LTA – in fact, most of us would regard it as a good thing. It’s simply that there are consequences in the form of a relief clawback. However, the LTA isn’t a hard limit – and it doesn’t stop you making further contributions.
The charge does not bite the instant you hit the LTA, however. Funds are tested when you start to take benefits and there’s only a charge when the benefits taken aren’t covered by the remaining LTA. Uncrystallised funds and the growth on crystallised funds are tested at age 75, but phasing retirement can defer LTA impact. Even when there is a charge, it will be deducted at source, so no-one has to fund it out of current income.
Why would you continue to contribute to a pension above the LTA limit?
Unless you have Fixed Protection, you may want to consider carrying on contributing if your employer pays into your pension but won’t convert that benefit into taxable cash. After all, it’s better to have a fraction of something than nothing. Similarly, there can be collateral benefits – dependants’ pension or death benefits, for example – attached to pension scheme membership that stop if you withdraw.
Other advantages remain, even after the LTA is exceeded: your pension still grows tax free; assuming that you have available annual allowance, relief is available at your highest marginal tax rate; contributions can still reduce your taxable income below the £100,000 threshold at which your personal allowance is reduced; and your pension is protected from inheritance tax.
Do you have alternative options?
There are other options to consider if you would rather stop contributions to avoid a tax charge. Channelling £20,000 into an ISA, with no upper limit on total savings and tax-free income, for example, speaks for itself.
Other alternatives are less obvious. Usually written around a life policy, single premium offshore investment bonds allow tax-free roll up of the fund during the bond’s life, but income tax is due on the growth at maturity. By that time, however, you may pay tax at lower rates and a form of relief mitigates the worst effects of taxing several years’ growth at once. The bond comes with a useful ability to withdraw cash at up to 5% of the original bond value annually. That cash is capital rather than income and so is tax free. Also, the basic bond structure can be tweaked to good effect for inheritance tax planning.
Family investment companies have become popular over the last decade. A UK company is set up to hold investments for family shareholders and, although it is funded from taxed income, the family can take advantage of lower corporation tax rates and a suitable share structure to direct benefits appropriately.
Approaching the LTA will become a reality for some now that the limit has been frozen until 2026. Ultimately, whether to continue contributing or not is a decision you need to take based on your own circumstances, but it’s worth taking some advice and doing the maths before ditching your scheme.