More clients than ever could face a 55% tax through breaching the lifetime allowance. Fiona Murphy asks advisers about the issues and action to take
Some 360,000 people will be hit by the latest lifetime allowance (LTA) reduction and 140,000 people will be hit by the annual allowance (AA) change, according to Treasury estimates.
Breaching the LTA can mean a 55% charge on any lump sum above the LTA or a 25% charge if no lump sum is taken. Anyone who exceeds the AA limit plus any unused annual allowance carried forward from the three previous tax years will also be taxed.
This has been the second time contribution limits have been cut under the Coalition's watch. Advisers are left on the frontline, explaining to more people they will have to plan or face penalties.
However, Skandia's head of retirement planning, Adrian Walker fears the announcement may have been eclipsed by RDR.
"There's a danger this has dropped under the radar," he says. "If people feel they might be threatened by the drop in the lifetime allowance, they need to start thinking about it now in terms of how they might want to build up and contribute before the end of the tax year."
Who is affected?
With last year's reduction to £50,000 and now £40,000, who will be affected?
Barnett Waddingham partner Bhargaw Buddhdev says: "Clients are finding this is not just going to affect senior people but middle management who tend to be long-serving members of the pension scheme and have salaries of about £80,000."
Individuals earning a rapid promotion could quickly find themselves in danger.
MGM Advantage's pensions technical director, Andrew Tully says the self-employed and small business owners may also be in the firing line due to fluctuating contributions based on profits.
Ian Linden, technical manager at James Hay Partnership warns while individuals consider their own contributions, they may forget employers' contributions which also need to be taken into account.
The disparity between pension input periods and tax years are also causing a headache.
Linden says: "Where someone had made a contribution in excess of £50,000 in 2011/12, for tax relief purposes everything was fine. What they hadn't appreciated is that pension saving contribution would fall in the tax year of 2012/13 for annual allowance purposes. We've had enquiries where people have said we hadn't appreciated the pension input period was relevant."
A vital opportunity
Advisers have a vital opportunity to engage with clients before the LTA and AA reductions come into effect in 2014. Tully says: "Where an adviser can add value is by flagging in advance and saying can we stop any additional payments being made or use carry forward?"
Those who are still contributing to a pension but are reaching limits can take a less risky investment strategy or favour alternative tax wrappers.
Tully says: "Putting money into ISAs or a partner's pension [or a children's pension] is a good way to get around it. It would be reasonably rare for both partners to pay in £50k, so there might be scope to move contributions around."
Buddhdev adds that "early retirement may reduce or eliminate the lifetime allowance tax charge. If they retired early, there is likely to be a reduction in the amount of pension they receive, which would reduce the benefits to below the lifetime allowance."
"However, early retirement does not necessarily offer best value. I usually compare the present values, net of all tax charges, of retiring later and paying the lifetime allowance tax charge and retiring early on reduced benefits.
"For example, if someone retired three years early at age 62, they will get three more years' pension, but it may have been reduced by early retirement factors in excess of 5%-6% for each year they draw benefits early.
"We look at the net present value to see the reduced pension with no tax, or the higher pension which is deferred to normal retirement age, but then there's a tax charge."
Employers can also alleviate matters by identifying key employees likely to be affected or negotiating benefit packages for new recruits.
Buddhdev has seen employers restricting pensionable salary or choosing to pay employees cash rather than contributions, although this is often more costly for companies with National Insurance deductions.
Ian Price, divisional director for pensions at St James's Place, says: "If their member of staff has contributions greater than £40k, [employers might] reduce their contributions and increase their salary in lieu of that. That's difficult on final salary schemes. If the deemed contribution is greater than £40,000, it might be worth paying the tax because the benefit you're getting after the tax is so great."
Fixed protection was bought in April 2012, to shield people from the first LTA reduction to £1.5m. Individuals had to register for this protection with HMRC. Will similar protection be available now the lifetime allowance has been reduced further to £1.25m?
Walker says: "People will be able to register those savings they've built up by the end of the next tax year using fixed protection two. It will be the same rules except the lifetime allowance protected is up to £1.5m.
"However, there is another aspect we don't have details on yet. They are consulting on the concept of people being able to [contribute further] but protect the value of the savings built up. I think the way it's going to work is, if my pension savings are valued at £1.4m next tax year, I will be [eligible for] this new form of personal protection. [With a] personal allowance of £1.4m, you can still contribute and get tax relief on contributions going forward, whereas fixed protection says you can't."
While protection has its advantages, there are risks individuals need to bear in mind.
Buddhdev says: "If someone has registered for protection and opted out of the scheme, they need to [check] if there is any life cover linked to pension scheme membership. They must make arrangements so life cover continues [such as a] separate unapproved life policy."
Price warns that those applying for protection under the new regime as well as those who already have fixed protection face further challenges with the advent of auto-enrolment.
He says: "If someone has made a decision not to fund a pension for tax reasons, they have to be aware they have to opt out if their employer auto-enrols them. I have a fear that the one [individual] with enhanced or fixed protection goes on holiday, their employer puts them in, and low and behold they're in the scheme and can't do anything about it."
As those with fixed protection are unable to make further contributions to a pension scheme, the fact they have been auto-enrolled could make this protection void and leave them open to a sizeable tax charge. We are waiting to see whether those applying for protection under the new limits will be in a similar boat.
However, this is a significant issue and one for government to take up when reviewing auto-enrolment conditions. In the meantime, advisers and employers must be vigilant and use strong communications to ensure that individuals mitigate pension tax burdens effectively.
The allowance of a lifetime
• In 2011/12, the LTA was reduced from £1.8m to £1.5m. The annual allowance was reduced from £225,000 to £50,000
• In the 2012 Autumn Statement, it was announced the maximum tax-free amount people can take from their pension over their lifetime will be reduced from £1.5m to £1.25m in 2014/15.
• The tax free annual contribution allowance was also reduced from £50,000 to £40,000.
• When the lifetime allowance was reduced to £1.5m savers likely to breach this amount were able to apply for fixed protection. This safeguarded them against tax charges as long as they stopped contributing to a pension scheme. Protection details under the new regime are yet to be finalised.
‘Important to have an anchor’
Report to be written by TPR
Lack of innovation for solutions
Some 2,000 consumers affected