Having £1m in your pension is an enviable position to be in, but those with pots nearing this size, or bigger, face punitive tax charges on their retirement income — and there are many more people affected than you might think.
While a seven-figure sum may sound far off to those starting their careers, Money can reveal that about 900,000 people — roughly 3% of Britain’s workforce — have pension savings close to or higher than the £1m lifetime allowance, according to the adviser Hargreaves Lansdown, which analysed new data from the Office for National Statistics.
Go beyond that £1m limit, and you could face a tax charge of 55% on some of your pension savings.
The people most likely to be affected are those in their fifties and sixties who have saved assiduously for many years, particularly those with generous workplace pensions that are less common today.
They are at an age when they can consider drawing on their funds — a move that could trigger the tax charge. Since April 2015, anyone aged 55 or over has been able to withdraw some or all of their retirement pot and do with it as they please. Savvy savers want to know how to take advantage of these life savings without giving too much to the taxman.
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The problem has been made worse by a steady reduction in the lifetime allowance, which was introduced in 2006 at £1.5m. It rose to £1.8m in 2010, but a series of cuts shrank it to the current figure of £1m in 2016. The limit is due to rise to £1.03m in April, and then increase each year in line with the consumer prices index measure of inflation, though there is no guarantee it will not be cut again or scrapped altogether.
The shifting goalposts make it difficult for advisers, let alone individuals, to know the best course of action, and it is not just lavishly paid investment bankers or company directors who need help deciding what to do.
“Far from being a squeeze on the highest earners, the lifetime allowance acts to penalise those who have prudently saved and successfully invested their pension,” said Nathan Long at Hargreaves Lansdown. “With global stock markets soaring, more and more people will be dragged into having to navigate this tricky tax trap.”
The former pensions minister Sir Steve Webb, now director of policy at the insurer Royal London, called the allowance a “tax on success”. He said: “Having a pot size limit means that if you invest your money well, you risk running into penal taxation, which seems crazy.”
More people will have to consider the impact of the lifetime allowance at some point in their career because of the introduction of auto-enrolment, said Carolyn Jones, head of pensions product at the investment company Fidelity International. This requires employers to offer pensions for staff, and the minimum contribution is set to rise from 2% of earnings to 5% in April, then to 8% next year.
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It is up to you to find out the size of your total retirement savings and take steps to maximise the benefits, but this is a complex area and professional advice is highly recommended.
Most people will have more than one pension. These may be defined-benefit schemes, which pay a predetermined income at retirement, or defined-contribution schemes, where the income depends on how much has been paid in over the years.
When is the tax charge triggered?
Your pot will be tested against the lifetime allowance when there are what are known as benefit crystallisation events, such as beginning to draw money from your pension or reaching the age of 75. At these times, any excess over £1m — when all your pots are added together — will be taxed depending on how you take the money. If the excess is taken as a lump sum, the charge will be 55%. The same charge will apply if you are a higher-rate taxpayer and take the excess as income. Additional-rate taxpayers will have to fork out slightly more, while basic-rate payers will be charged less.
How do I protect myself if my fund is approaching £1m?
For those with a defined-contribution pension, also known as a money purchase scheme, the size of your pot — and, ultimately, the size of the pension you can draw — depends on how much you and your employer have contributed over the years, coupled with how that investment has grown.
If you are still saving into a workplace scheme and think you are on target to reach £1m, you could ask your employer to stop contributing to your pension and give you the money in cash, which could be invested elsewhere, such as in an Isa. This would slow the growth of your retirement fund.
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Your employer is under no obligation to agree, though. Also, experts warn against giving up this contribution; it is far better to take the money, even though you will pay a large chunk of it in tax.
“It may seem counterintuitive to suggest any action that will knowingly lead to a tax charge, but the relative merits need to be weighed up,” said Patrick Connolly of the adviser Chase de Vere.
Should I invest in lower-yielding investments?
If you are close to the lifetime allowance, you may be tempted to move your money to less risky but lower-growth investments. Jones at Fidelity International is sceptical about this approach. “It may still be worth aiming for higher returns, particularly if you are a long way from retirement,” she said.
“It’s better to have 45% of something than 100% of nothing. Not earning a good return just so you don’t pay tax on it is like saying you don’t want to work because you’ll have to pay tax.”
Should I take my tax-free lump sum?
Under the current pension rules you can take 25% of your pot tax-free, in one lump or several, once you reach the age of 55.
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Imagine you have a total of £1m. If you withdraw the maximum allowed, £250,000, the remaining £750,000 will be placed in what is known as drawdown. Because you have reached 100% of your lifetime allowance, you will not be able to take advantage of future rises in the limit.
You can then avoid the punitive tax charge by regularly withdrawing gains made by the money left in your fund.
You will have to pay income tax on these withdrawals at your highest rate, but this will prevent you from breaking the limit when your fund is valued at the next crystallisation event, which will be when you reach your 75th birthday or if you buy an annuity before that age.
What are the implications for inheritance tax?
Money that is left in your pension, even after you start to draw on it, is not normally considered part of your estate for inheritance tax purposes, which means more money for your heirs.
If you die after the age of 75, however, your beneficiaries will have to pay income tax on any money they draw from your pot at their top rate. If you die before 75, no income tax will be levied.
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Any money you have already withdrawn and not yet spent, such as your tax-free lump sum, will form part of your estate and be liable to inheritance tax. You can mitigate this by giving away some or all of this money, though if you die within seven years, such gifts will be subject to tax.
How do the rules differ for defined-benefit schemes?
These pensions, also known as final salary or career-average schemes, work differently in that they guarantee an annual income at a certain age regardless of how financial markets perform.
A formula is used to work out whether savers have reached the lifetime allowance: the annual income is multiplied by 20, and any tax-free cash paid is added to give a total figure.
In other words, you are likely to be considered to have hit the £1m mark if you are guaranteed a pension of £50,000 a year or more.
You can get round this by taking a lump sum. If, for example, your scheme allowed you to receive a one-off payment of £120,000 in return for a lower annual pension of £40,000, your fund would be valued at £920,000 (£40,000 x 20, plus £120,000), keeping you below the threshold for the penalty charge.
Another solution may be to retire early, although schemes’ rules on this differ. Rather than taking £50,000 a year from the age of 65, you may have the option of receiving, say, £40,000 a year if you give up work five years early, which would again ensure you did not reach the lifetime allowance ceiling.
My fund is already worth more than £1m. What can I do?
The government introduced specific protection for those with seven- figure pension pots when the lifetime allowance was reduced from £1.25m to the all-time low of £1m in April 2016.
If you have not done so already, you can apply for what is known as fixed protection 2016 to maintain your allowance at £1.25m. This is only possible, however, if you have not made any contributions since April 5, 2016.
All is not lost even if you continued to make contributions, as you may be able to apply for “individual protection 2016”, which provides a personal lifetime allowance equal to the value of your pension on April 5, 2016, up to a maximum of £1.25m. This allows you to continue contributing to your pension, but you will have to pay the punitive 55% rate on anything you take from that part of the pot that exceeds your personal limit.
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Are you at risk of going above the lifetime allowance? Email money@sundaytimes.co.uk