The Annual and Lifetime Pension Grant Explained
The annual and lifetime pension tax credits limit how much people can take advantage of tax breaks on their pension pots and have made headlines due to recent changes.
We explain the allowances and what they mean for you.
New annual limits explained: How much can YOU save tax-free for your pension?
Everyone is allowed to save up to a fairly generous amount of untaxed income for retirement each year, including top earners.
That’s the underlying principle of the pension tax credit, and that’s the most important thing to think about before delving into all the associated allowances and rules.
The retirement tax credit works so that based on your income tax rate of 20 percent, 40 percent, or 45 percent, you receive a rebate or a supplement from the state that goes into your pension.
These put you back in the position you were in before income tax.
But there are limits to how much you can save without paying a penalty, although the annual rules were made much more generous in the last Budget – and the current lifetime cap of around £1.1million will be scrapped from 6 April 2023.
You can read the full overview of the pension budget changes here and below we explain how the system works now and after the new rules come into effect.
What is the annual fee?
The annual allowance is the standard amount that you can put into your pension each year and for which you are entitled to tax relief on the savings.
It is currently £40,000 or up to 100 per cent of your annual income if it is lower, but will increase to £60,000 or your income level from 6 April.
The annual allowance includes your own and your employer’s contributions to a pension and the tax relief itself.
The rules are more complicated for higher earners, whose annual allowance was previously reduced to just £4,000, but this will be changed to a more generous £10,000 from April 6.
The annual allowance is reduced for people with an adjusted income level – including pension contributions – of £260,000.
It will be reduced by £1 for every £2 of ‘adjusted income’ above that figure, but only up to the new £10,000.
The threshold income from which people’s annual income is calculated for pension tax relief purposes is £200,000.
What are the deadlines for using the annual flat rate?
A very important advantage of the annual tax allowance is that under certain conditions you can still benefit from what has not been used in the previous three tax years.
You must have been a member of a pension insurance scheme in the years from which you want to “transfer” the annual allowance, but you must not have paid anything into it.
This often hits people like the self-employed who have neglected retirement planning and are trying to build a pension from scratch.
Also, you must first use your entire annual allowance for the year you want to carry forward, and you must go back to the earliest of the three years and use the first year allowance from that point forward.
What are defined contribution and final salary pensions?
Fixed Post Pensions take contributions from employers and employees and invest them to provide a pot of money in retirement.
Unless you work in the public sector, they have now mostly replaced more generous, gilded fixed-term or terminal salary annuities that provide guaranteed income after retirement until your death.
The carryover has become even more valuable now that the lifetime allowance is being eliminated because if you can afford it, you can catch up on your savings to an even greater extent.
It is often used by people who want to earn significantly more money later in life or inherit money and want to save it in a tax-efficient manner and perhaps also want to pass on their defined contribution pension free of inheritance tax.
Beneficiaries either pay no tax on what’s left in a defined contribution scheme if the owner dies before age 75, or pay their normal income tax rate if they’re 75 or older.
What happens if you exceed the annual allowance?
It’s not illegal, but you’re not effectively getting any tax credit for excess pension contributions, as that amount is added to your taxable income and is subject to income tax.
This is called the annual fee.
You can check with your pension provider if they will allow you to use a ‘scheme pays’ system, meaning the fee will be deducted from your pension instead.
It is also possible to use the carry over to cancel or mitigate the burden.
What is the “Money Purchase Annual Allowance” or MPAA?
This allowance is intended to discourage people from investing their pensions back into their pots to benefit twice from tax breaks.
Anyone who has paid more than the tax-free flat rate of 25 percent will be prevented from benefiting too much from the valuable contribution relief.
The new reduced annual savings limit for allowances has been £4,000 since 2017, but will increase to £10,000 from 6 April.
Pension industry experts argued that the lower figure is a barrier to retirement planning for people who want to return to work while increasing their pensions.
The MPAA was originally £10,000 when it was introduced in 2015, along with pension freedoms which made it much easier to claim pensions from the age of 55.
What does the abolition of the lifetime allowance mean for you?
Chancellor Jeremy Hunt is dropping the total limit of £1,073,100 people can have in their pension pot without facing tax penalties from April 6.
He was expected to increase the limit to £1.8million rather than scrap it outright. So this was a noticeable but controversial move to retain higher earning workers.
Labor has promised to reinstate the lifetime allowance if it wins the next election, which should be taken into account if it could affect your pension plans.
The lifetime allowance includes both the money savers and their employers paid into the pensions, plus any increments over the years.
As with the annual allowance, you can continue to save beyond that, but you’ll face fees to reclaim any tax relief — a 25 percent fee on income and a 55 percent fee on a lump sum.
Pension experts predict a flood of new money into the pensions of the better off, but you should seek professional advice to avoid pitfalls.
If you already have that amount saved in an annuity, it makes sense to pay for financial advice, particularly on how the carryover rules might affect you, and for “solid protection” that allowed people to get their LTA as long as they freeze at older, higher limits they stopped making further contributions.
There’s also the issue of the 25 per cent tax-free lump sum, which has been capped at £268,275 – a quarter of the current LTA limit – unless you have fixed protection. In this case, the higher amount may apply even if you start paying back into your pension.
When Labor introduced the lifetime allowance in 2006 it was £1.5m, but has been gradually increased to £1.8m for the 2010/2011 tax year.
However, it was then cut by Conservative Chancellors George Osborne and Philip Hammond, falling to as low as £1m in 2017/2018 before gradually raising it again.
If the lifetime allowance had risen in line with inflation since 2006, it would now be £2.66million, according to This is Money’s inflation calculator.
For someone with a defined contribution pension that remains invested and is drawn at a standard rate of 4 per cent annually, the current lifetime allowance equates to income of £43,000.
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