Strict rules on how much pension benefits you may accumulate before retirement mean NHS Pension Scheme members could be hit with a tax charge of 25% on their Pension income which after income tax could potentially equate to a 55% tax charge.
Given that we’re constantly urged to put more money by for retirement, you might think you could never save too much towards your pension. But you’d be wrong: since 2006, the Government has capped the amount of pension savings you’re allowed to build up – go over this lifetime allowance and you’ll have to pay punitive charges on the excess.
Since its introduction, the lifetime allowance has fluctuated considerably. Originally set at £1.5m, it was gradually raised to £1.8m, but has been falling since 2012 as successive governments have made reductions. In the 2017-18 financial year, the allowance is set at only £1m; the Government has now pledged to increase it each year in line with the consumer prices index (CPI) measure of inflation, so in 2018-19, it will rise to £1.03m.
What’s my pension worth?
The crucial point about the lifetime allowance is that it’s a cap on the total capital value of all your pensions that have enjoyed tax relief.
In defined contribution schemes, where you build up a pot of pension cash over time to fund a retirement income, working out your potential exposure to the Lifetime Allowance is easy: you just add up the value of all your pension funds.
However, life isn’t so simple in defined benefit schemes such as the NHS Pension Scheme, where you’re building up a guaranteed entitlement to a certain level of pension, rather than a cash sum. In these schemes, the value of your savings for lifetime allowance purposes is your annual pension income at retirement multiplied by 20 plus your tax free lump sum.
For example, if you are a member of the 1995 section of the NHS Pension scheme and retire with a pension of £50,000 and a lump sum of £150,000, your pension is valued at £1.15m against a current lifetime allowance of £1m. This is calculated by multiplying your annual pension by a factor of 20 and adding on the value of your lump sum; this means you have a lifetime allowance excess of £150,000.
What are the charges?
The tax charges on excess savings above the lifetime allowance depend on how you take the money.
Under the NHS Pension Scheme the tax charge is usually paid on the income at a rate of 25%. There may be circumstances where a member exceeds the maximum permitted pension commencement lump sum and takes it as cash. In these circumstances you will have to hand over 55% of the cash to HM Revenue & Customs.
The factors are different in Scotland compared to England, Wales and Northern Ireland, but are available on the relevant Pension Agency websites.
You do have the option to commute part of your pension income for a larger lump sum. There are restrictions on the maximum lump sum available. If the maximum you are allowed to commute exceeds 25% of the standard lifetime allowance (or your own protected lump sum amount), and you follow this route, any lump sum excess is taxed at 55%
Can I avoid the charges?
The simplest way to avoid the lifetime allowance charges is not to exceed the cap, which means keeping a close eye on your pension savings well ahead of your eventual retirement if you’re in any danger of going over the limit. Still, for many, particularly those in defined benefit schemes such as the NHS Pension, accruing further benefits, even where this incurs a tax liability, may still be the best course of action. Take professional independent financial advice on how to manage this risk and never make assumptions, particularly about opting out, which could prove costly.
There are also several schemes in place to protect savers who were already over the lifetime allowance, or close to it, when the rule was first introduced, or when the cap was subsequently changed. In certain cases, you can still apply for this protection; in others, the opportunity has now gone. The schemes are:
- Enhanced Protection – this allowed anyone to protect their pension fund from the lifetime allowance, subject to some strict conditions, including making no further contributions to any money purchase pension arrangements, limiting the further accrual of benefits in defined benefit pension arrangements such as the NHS Pension Scheme, or joining any new scheme. This all applied to members prior to 6th April 2006 and you needed to have applied for the protection prior to 6th April 2009.
- Primary Protection – this allowed you to protect your savings from the lifetime allowance while continuing to accumulate pension funds, subject to a formula determining how much of your pension would be protected. Again, the deadline for applications was 5 April 2009. In order to apply for this protection the capital value of your pensions as at 6 April 2006 had to exceed £1.5m
- Fixed Protection – in 2012, this allowed you to protect your savings from the reduction of the Lifetime Allowance to £1.5m and keep the existing lifetime allowance of £1.8m (or a higher amount if the standard lifetime allowance exceeds your protected figure by the time you retire). You had to apply before 6 April 2012.
- Two years later, a second version of Fixed Protection was made available, when the lifetime allowance was reduced to £1.25m. It worked in the same way, by fixing your lifetime allowance at the previous level of £1.5m (the standard lifetime allowance applies instead should this be higher than £1.5m when you retire). The deadline for applications for this protection was 5 April 2014.
- Finally, in 2016, a third version of Fixed Protection was introduced, to reflect the reduction of the lifetime allowance to £1m. You can still apply to this scheme, which works in the same way as its predecessors by fixing your lifetime allowance at the re-reduction level (£1.25m in this case), but not if you have continued to make money purchase pension contributions or have had defined benefit accrual since 6 April 2016.
- Individual Protection 2014 – introduced in 2014, this scheme gives you a protected lifetime allowance equal to the value of your pension rights on 5 April 2014, but capped at £1.5m (total benefits on 5 April 2014 had to exceed £1.25m). The deadline for applying was 5 April 2017. You don’t lose this protection if you make further pension savings.
A new 2016 version of individual protection was introduced in 2016, which is still open for applications. It gives you a protected lifetime allowance of up to £1.25m and is valuable for NHS Pension Scheme members whose total pension benefits were worth more than £1m on 5 April 2016. It allows pension funding to continue.
In next month’s Newsletter we’ll explain the strict rules that apply to Enhanced Protection and the impact on GPs and doctors who have joined the 2015 Pension Scheme; we’ll also look at how to apply for Individual Protection 2016 and Fixed Protection 2016.
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