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‘Why savers should not
(always) be afraid of the Lifetime Allowance’

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The Lifetime Allowance (LTA) for pension tax savings was introduced in 2006 as an attempt to cap the total amount of pension tax relief which an individual can enjoy over the course of their lifetime. The Allowance level has varied, peaking at £1.8m in 2010/11, since when it has been subject to a series of cuts, followed by a freeze, followed by an inflation link, followed by a five year freeze at just over £1m, due to end in 2026.

The severe cut in the real value of the LTA means that growing numbers of savers will need to factor in the LTA into their retirement planning.

However, new analysis from consultants LCP shows that in some situations savers may achieve better outcomes by continuing to save in a pension, despite expecting to breach the LTA, rather than stopping pension saving. The three main scenarios which they highlight are:

  • Employees who benefit from an employer pension contribution which would be lost if the worker opted out of pension saving; this is particularly true for those in Defined Benefit pensions where employer contributions can be very substantial;
  • Those who pay a higher income tax rate when in work than they will pay in retirement; in some cases, the high marginal rate of tax relief on contributions will more than compensate for an LTA tax charge plus income tax in retirement, especially in the presence of an employer pension contribution;
  • Those earning between £100,000 and £125,140; this group face a marginal income tax rate of 60% because of the gradual removal of their personal income tax allowance as their income rises; pension saving is particularly attractive for this group.

However, the research shows that the self-employed (and others who do not benefit from an employer pension contribution) may find that if they expect to reach the LTA they should consider directing marginal savings to another vehicle such as an Investment ISA. Note that all of these calculations assume that the contributions are not of a level that would be impacted by the pensions Annual Allowance.

To measure the tax treatment of additional pension savings for those who have reached the LTA, LCP compared £100 (net) of extra savings into a Defined Contribution pension with £100 into an ISA, assuming the same rate of investment return could be achieved in each case (and noting that both deliver gross investment returns). As the same investment return is achieved whichever option is chosen, the analysis stripped out investment growth and looked just at tax and contribution effects.  It showed how the outcome varied according to the marginal income tax rate of the saver whilst in work and what might turn out to be their income tax rate in retirement.

Results

Baseline: £100 of post tax income invested in an investment ISA yields £100 of post tax outcome, ignoring investment growth. This means that if saving in a pension yields more than £100 net of tax in retirement, it is to be preferred to the ISA option, other things being equal. Even if the return was the same from the two options, the pension option could still be preferable especially in an employer arrangement, because of ‘add-on’ benefits associated with some pensions such as life insurance and pensions for survivors. (On the counter side, pension contributions are locked up until retirement age.)

  1. Alternative 1. Self-employed person with no employer contribution puts £100 into a pension already expected to reach the LTA – what do they get back after tax?
 

Marginal income  tax rate out

       
 

0%

20%

40%

60%

45%

Marginal tax rate in

         

0%

£75

£60

£45

£30

£41

20%

£94

£75

£56

£38

£52

40%

£125

£100

£75

£50

£69

60%

£188

£150

£113

£75

£103

45%

£136

£109

£82

£55

£75

Note: For the purposes of the table it is assumed that the additional pension is taken as income (eg annuity or phased drawdown) rather than as a lump sum.  This generates an LTA charge of 25%.

Explanatory note: “Put £100” is shorthand for ‘makes contributions so that take home pay reduces by £100’.  For full explanation of these calculations, see notes.

The table shows that, for example, someone who was a basic rate taxpayer in work and is a basic rate taxpayer in retirement (assuming this continues to be 20%) would end up with £75 net of tax for a £100 net of tax Defined Contribution pension contribution. This is worse than the outcome with an ISA. 

One group that does especially well from pension saving even in this scenario is those in the band of earnings from £100,000 to £125,140 who face an effective marginal tax rate of 60%.  This is because their income tax personal allowance is gradually withdrawn as their income rises across this band, and that adds to their marginal tax bill on top of their 40% marginal rate.

For those in this band, extra pension saving is almost always attractive, except in the (presumably rare) case where they also end up in this income band in retirement.

  1. Alternative 2. Employee with ‘matched’ employer contributions puts £100 into a pension already expected to reach the LTA – what do they get back after tax?
 

Marginal income  tax rate out

       
 

0%

20%

40%

60%

45%

Marginal tax rate in

         

0%

£150

£120

£90

£60

£83

20%

£188

£150

£113

£75

£103

40%

£250

£200

£150

£100

£138

60%

£375

£300

£225

£150

£206

45%

£273

£218

£164

£109

£150

Note: the employer match is assumed to be £1 per £1 gross of employee contribution.

In this case, the attractiveness of pension saving in the vast majority of cases can be clearly seen, even though the saver has reached the LTA.  For example, someone who is a basic rate taxpayer in work and in retirement gets £150 net of tax for a £100 contribution, even after allowing for the LTA charge.  This is because the value of the ‘matching’ employer contribution more than offsets the tax charge.  Note that this simply assumes £-for-£ matching of contributions as in a Defined Contribution pension arrangement.  It also assumes that the employer is not willing to offer a cash alternative to the employer pension contribution if the workers opts out.

In a Defined Benefit arrangement, the employer contribution could easily be double that of the employee which would further increase the relative attractiveness of pension saving.

What if you take your “excess” pension as a lump sum?

So far we have assumed that the pension in excess of the LTA is eventually taken as regular income, so generates an LTA charge of 25% plus normal marginal income tax.

The alternative is to take the whole excess as a lump sum. The LTA charge in this case is 55% with no further taxation.  This means that the net position depends only on the saver’s marginal rate in work and is not affected by their marginal rate in retirement.

The table shows outcomes for a £100 contribution in the same two scenarios as above – ‘self-employed’ (ie with no employer contribution) and ‘employed’.

Marginal tax rate in

self emp

Employee with employer matching

0%

£45

£90

20%

£56

£113

40%

£75

£150

60%

£113

£225

45%

£82

£164

In this case, the ISA route dominates the pension route in almost all cases in the absence of an employer contribution, but pensions look better for everyone except non taxpayers in the case where there is also an employer contribution.

Commenting, Karen Goldschmidt, partner and pensions tax specialist at LCP said:

“It would be easy to assume that you should try at all costs to avoid breaching the Lifetime Allowance. But this analysis shows that this is far from being the case. If opting out of a pension means throwing away an employer pension contribution, this is rarely the best approach, especially in the case of Defined Benefit pensions where the employer contribution can be very substantial.  The attractions of pension saving are particularly notable where someone expects to pay a lower rate of tax in retirement than they are paying whilst of working age. But for those who do not benefit from an employer contribution, the Lifetime Allowance may be more of a reason for a pause in pension saving, with other options such as an investment ISA being more attractive in some situations”.