The lifetime allowance: paying more tax can sometimes be worthwhile

14 March 2014

With the lifetime allowance for retirement benefits falling to £1.25m on 6 April 2014 more people are likely to have pension funds that will exceed this by the time they retire. But not everybody whose funds reach this level should automatically stop future pension contributions:

  • People in defined benefits schemes should consider carefully before deciding to opt-out.
  • Those in defined contribution schemes who are expecting significant investment returns and are many years away from drawing benefits.
  • Cases where any cash alternative offered by an employer is less than the contribution that would otherwise be paid into the pension scheme; cash may not be better value.

If you have a choice between making a pension contribution and taking the equivalent amount as taxed cash then there is a trade-off. If you pay 45% tax then cash would be taxed at 47% (45% plus 2% National Insurance) and, if the net amount were invested, the investment returns would also be taxed. Alternatively, a pension contribution would enjoy tax-free investment returns but would be taxed at 55% on distribution. The key question is whether the value of gross investment returns within the pension scheme, but taxed at 55% on the way out, is worth more than the value of net investment returns on cash, which is taxed at 47%.

Is the value of tax-free investment growth in the pension scheme, compared to taxed investment growth on private investments, worth more or less than 8% of the funds (being the difference between 47% and 55%)? It depends on some unknown factors such as future investment returns, for how many years the funds will be invested, will the lifetime allowance have risen again by the time you retire and what might future tax rates be?

If you are close to drawing benefits or don’t expect significant investment growth you probably wouldn’t want to make further contributions that would exceed the lifetime allowance.

But, the 55% penalty for exceeding the lifetime allowance, versus tax on cash of 47%, isn’t large for a top-rate taxpayer and it’s is reduced if the cash alternative is less than the amount that would otherwise go into a pension scheme. So in some cases it might be worthwhile going over the lifetime allowance, particularly if you’re 10 or more years away from drawing benefits and you’re expecting reasonable investment returns in the future. 

Say, for example, your pension contribution was £100 but the alternative cash offered by your employer was only £88 to reflect the employer’s National Insurance paid on cash but not on a pension contribution. Your pension contribution of £100 would be taxed at 55% when the funds are withdrawn, and so would give you £45. The cash would be taxed at 47% and so a payment of £88 would give £46.64 after tax and National Insurance. It wouldn’t take more than maybe four years of reasonable investment returns in a tax-favoured pension scheme, compared to investing privately with tax imposed on personal investments, to offset this small difference.

By contrast, it would very rarely be worthwhile exceeding the annual allowance unless the alternative cash supplement was such poor value that the pension accrual after the penalty for exceeding the annual allowance was still worth more than the cash alternative. This is because the annual allowance imposes tax at marginal rate on contributions and then the benefit is taxed again at marginal rate when it’s distributed. Exceeding the lifetime allowance means paying tax once, albeit at 55%, but exceeding the annual allowance means being taxed twice, at marginal rate each time.

 

To read more of our pensions related articles, please follow our Pensions blog.

As always, you should seek independent financial advice before making decisions in this complex area.

 

 

Tim Sexton | Director
Profile | Email | +44 (0) 207 212 3943

 

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