Wake up to threat of pension tax charge
Thousands of investors are sleepwalking into a massive tax charge on retirement ahead of new rules limiting the amount that can be saved in pensions, experts have warned.
The maximum an individual can accrue in pensions benefits without facing a heavy tax bill will be cut from £1.8 million to £1.5m next April, under changes to the lifetime allowance (LTA).
And while the cap remains out of reach for most people, advisers warn that many pension savers could be in danger of breaching the limit without realising it. Pension savers 20 years from retirement and with around £500,000 in pension benefits could easily be affected.
Under the changes, those who have built up more than £1.5m in pension benefits – not including the state pension – will be hit with a 25 per cent tax charge on the amount above the LTA that is paid in the form of a pension. If the amount above the limit is paid as a lump sum, tax will be charged at 55 per cent.
The danger lies in how deceptively quickly pension funds can accumulate, particularly in final salary schemes. The cap affects both those in defined contribution pensions – into which most people in workplace schemes now pay – and members of final salary schemes who are entitled to a pension of £75,000 a year, said David Gow, a financial planner at Acumen Financial Planning in Edinburgh.
He gave the example of someone who has built up pension benefits of £2m. They will now have to pay 55 per cent tax on £500,000, as opposed to £200,000 previously, amounting to a tax charge of £275,000 instead of £110,000.
‘This is a serious issue because it means a growing number of people who received tax relief of 40 per cent when they paid money into their pension will be taxed at 55 per cent when they draw the funds out – an effective unfair tax hit of 15 per cent,’ said Gow.
Someone with a salary of £130,000 to £150,000, has 40 years’ service and is in a scheme whereby benefits accrue at a rate of an 80th of salary per year will be hit. ‘Based on the current lifetime allowance, those on salaries of £170,000 or more are potentially affected,’ said Gow.
The prospect of a hefty tax charge is also realistic if you have a fund of around £1m, even if you make no more contributions and are planning to retire in five years or so.
Bryan Innes, senior client partner at financial advisers Towry, explained: ‘A pension fund of £1m with annual contributions of £50,000 a year would in five years see the potential fund value increase beyond the new limit.’
The further from retirement you are, the greater the chance of breaching the limit, Innes added. ‘A 40-year-old with a fund value of £500,000 and even with no more contributions could see the fund grow to more than £1.9m, optimistically assuming fund growth of 7 per cent a year, giving a potential tax charge of more than £239,000. Yes, the LTA may change in the future, but individuals need to be aware.’
So what can you do if you think you may be affected, even if you’re several years from retirement? One option is to stop paying into your pension.
Innes said: ‘It will impact upon a number of individuals with funds below the £1.5m LTA, and the advice for many could be to cease pension contributions or even opt out of their pension scheme. The limit is frozen until 2016, but there is no reason to believe it will not be for longer.’
Early retirement is another option, said Gow, particularly if you’re due to retire shortly after the new rules come into force next April. Alternatively you could crystallise your pension benefits earlier than you had originally planned, he added.
If you stop making pension contributions you can save instead into other vehicles, including individual savings accounts (Isas), into which you can save up to £10,680 tax-free a year. Gow added: ‘You get 30 per cent tax relief on investments of up to £200,000 a year in venture capital trusts, and 20 per cent on investments of up to £500,000 a year in an enterprise investment scheme.’
Even if your funds are currently well short of the £1.5m cap it’s worth looking ahead to make sure you don’t hit it. The first step is to find out how much your fund is worth and get a projected value at retirement. ‘Then review the underlying investment strategy to ensure it is in line with objectives and does not trigger an unnecessary tax charge,’ said Innes. ‘Once this is done you can look at a pension strategy that focuses on underlying investment growth as well as future contributions in respect of the LTA.’
You can take more formal steps to ensure you don’t suffer a big tax charge. From next year, people who expect their pension savings to exceed £1.5m when they come to take their benefits will be able to use ‘fixed protection’, which effectively keeps their LTA at £1.8m.
There are several caveats, however. If it is granted, you have to stop making contributions if you’re in a defined contribution pension. If you’re in a final salary scheme, the amount of benefits you can build up each year will be restricted. You would also be barred from opening any new pension arrangements, unless it is to receive a transfer of rights from an existing pension.
Gow said: ‘If you qualify for fixed protection and have a defined contribution pension, think about stashing significant sums of money into your pension before April, then apply for fixed protection.’
The right solution for you depends on your circumstances and independent advice is highly recommended. To find an IFA near you, visit www.unbiased.co.uk.
By David Gow
Published in Scotland on Sunday on