What is the pension lifetime allowance and how does it work?

Nov 25, 2022

While the vast majority of people won’t need to worry about breaching the pension lifetime allowance, this could change over the next few years.

The allowance is currently set at £1,073,100 and will be frozen at that level until 2025/26. So, while your pension pot may grow bigger, the total value of tax-free benefits you can build up from registered pension schemes will stay the same.

Whether you’re years away from retirement or likely to access your pension in the near future, understanding how the pension lifetime allowance works is essential. Here’s what you need to know.

What is the pension lifetime allowance?

Your allowance is the total value of tax-free benefits you can build up from your registered pension schemes. It applies to any savings you have from defined benefit and contribution schemes but excludes your state pension.

HMRC will work out whether you’ve passed the £1,073,000 mark through a series of checks. If the total value of your benefits exceeds the allowance, you’ll be taxed on the excess before receiving the rest of your pension.

When are the checks carried out?

You can typically expect checks to be carried out at these times:

  • when you start drawing a pension
  • if you transfer a pension overseas before age 75
  • if you turn 75 without touching one of your pensions
  • if you die before age 75 without touching one of your pensions.

It’s worth noting that if you pass away before accessing a scheme, HMRC will bill whoever inherits your pension. Also, there are usually no further checks against the lifetime allowance after your 75th birthday.

Knowing when these checks are likely to take place is crucial because what really matters is the value of your pension scheme when they’re carried out.

This means if you’re still a few years away from retirement, you’ll need to account for how the value of your pension may change between now and when you access your funds.

Any extra value will eat into what’s left of your lifetime allowance, so it may be worth reviewing your retirement strategy if you think you’ll exceed it.

How will the allowance affect you?

Whenever you access a pension scheme for the first time, its value will be compared against your remaining lifetime allowance. You can find out whether you’ll exceed the allowance by adding up the total value of all your pension schemes.

But be careful – how you calculate the value depends on a number of factors, such as the kind of scheme you’re in and how you choose to access your income.

For defined benefit pension schemes, you’ll usually need to calculate the total value by multiplying your expected annual pension by 20 and adding any separate tax-free lump sums onto the total.

Meanwhile, if you’re in a defined contribution pension scheme, you can access your pension pot in several ways, all of which will change how you calculate your total benefits.

Charges if you exceed the lifetime allowance

If the value of your pension benefits goes over the limit, you’ll be charged a tax called the lifetime allowance charge. This will apply differently depending on how you access the excess.

You’ll be taxed at 55% if you take out the excess as a lump sum, and your pension provider will usually pay the tax to HMRC before paying you the remaining 45%.

Meanwhile, you’ll face an immediate 25% charge if you decide to keep the money in the pension to take income from it, on top of any income tax you receive.

If you’re in a defined benefit scheme, the scheme may pay the tax on your behalf and reduce your pension accordingly.

Meanwhile, defined contribution schemes will likely pay 25% of your pension pot to HMRC, leaving the remaining 75% for your retirement income.

Navigating the pension lifetime allowance and performing complicated calculations can be stressful and time-consuming, so why not hire JP Harrison to give you a hand?

Get in touch to find out how our dedicated team can help you get ready for retirement.

Heard enough?
Let's chat

We’re happy to talk with you about anything – whether that’s a specific service, or something you’re not sure about, we’ll lend you an ear.