Should you be limited by the pension allowances?
To understand and be able to factor into financial planning strategy:
· the implications of the abolition of the lifetime allowance charge;
· the way in which exceeding the annual and lifetime allowances impact planning; and
· what to consider in the future with regards to possible changes still to come.
On the 15th March 2023, the Chancellor stood up and announced the increase in the annual allowances and the abolition of the lifetime allowance. However, the immediate changes, on the 6th April 2023, only saw the increases in the annual allowance, not the abolition of the lifetime allowance. That is still to come, but we have seen the specific tax charge on exceeding the lifetime allowance reduced to zero, meaning any benefits over and above the lifetime allowance are only subject to income tax, including any lump sums payable.
We are currently waiting for the full legislation to remove the lifetime allowance, but, even then, there will be limits on the tax-free payments through pension commencement lump sums, uncrystallised funds lump sums and lump sums paid on death or in serious ill health. Anything paid as income is planned to be taxed as income and therefore not subject to any tests. However, it does mean that, in essence, there are still limits on the amount of tax-free benefits payable which will at least, in part, drive where investments are placed, either in a pension or another vehicle.
Exceeding annual allowances
The annual allowance can be various amounts from £10,000 to £60,000, or even more with the availability of carry forward unless the Money Purchase Annual Allowance has been triggered. The check against the annual allowance covers all pension savings. This includes personal and employer contributions and benefit accrual in defined benefit (DB) schemes.
Determining if an individual should deliberately exceed the annual allowance is dependent on their circumstances and who is paying the contribution.
Contributions paid by an employer would still see the employer benefit from all the reasons to pay pension contributions, such as them (normally) being treated as a deductible business expense and as a form of remuneration that doesn’t attract employers’ national insurance (NI). However, any annual allowance charges would be borne by the individual. Salary sacrifice contributions would be treated in the same way here, although there may be additional benefits from any NI savings, particularly if employer NI savings are also paid into the individual’s pension.
Contributions made by an individual, will attract tax relief up to their relevant UK earnings, even if over the annual allowance including carry forward. The annual allowance charge is applied to recoup any tax relief on contribution amounts above the available annual allowance. This could still be beneficial for the individual when factoring in things such as the tapering of the personal allowance, which gives an effective tax relief of 60% whereas the annual allowance charge would only be at 40%, 45%, or a combination of both.
You also need to factor in what tax rate may be payable in retirement, which can be hard as it could be a long way off and we don’t know what rates (or other tax rules) may be applicable at that time. So, relying on this for justification could be a lot harder.
Exceeding lifetime allowances
Although the lifetime allowance is to be abolished, the plan is to introduce two limits on pension payments that can be made free of tax: an overall limit of lump sums and lump sum death benefits of £1,073,100; and a tax-free cash limit of £268,275. Funds in excess of the new allowances will not provide any additional tax-free cash and would mean that some or all death benefits will be subject to income tax even under the age of 75.
Even with the reduced benefits of pension savings above the new allowances there can still be a benefit if the individual is going to be paying less tax in retirement than they are paying on their earnings whilst working, particularly those who would be a 60% taxpayer when working and can use salary sacrifice to add to the savings benefits.
In addition, although we know pensions should be funded for the purpose of retirement income there are additional benefits such as inheritance tax savings that can be made when determining where to save excess funds. Pensions still give access in older age, grow tax efficiently and can often be left tax efficiently on death, including free from inheritance tax. That said, income tax on funds in excess of the allowances could reduce the benefit of additional savings should the beneficiary draw income that is taxable at higher or additional rates. And, again, we don’t know what tax rules might apply in the future.
Overall, we need to remember that we are dealing with allowances, in just the same way as we do for things like the personal allowance. You need to factor them into your calculations, but exceeding them isn’t a crime or even a breach of a limit, just an excess over an allowance that changes the taxation benefits. For each case, you need to consider both the tax rates now, the future landscape as well and the wants and needs of the clients, or beneficiaries.