In recent years the rise in house ownership in the UK and the increase in the value of UK homes have resulted in many more people having to pay Inheritance Tax (IHT) than in the past.  More and more UK taxpayers (and potentially overseas individuals with UK property) are being dragged into the IHT net.  Equally, on the pensions front, more and more pension scheme members will be subject to the lifetime allowance charge (LAC) or, at least, should be aware of it.

What is the LAC?

The LAC is a tax charge which was introduced from 6 April 2006 and which has so far only affected a minority of pension scheme members.  It is a tax charge which applies where pension scheme savings that have benefited from UK tax relief exceed the lifetime allowance.   The initial lifetime allowance was set at £1.5 million in 2006/7 and then increased up to £1.8 million before the UK Government decided that that was too generous and in recent years the lifetime allowance has been reduced to the current value of £1 million (2016/17).

The charge applies whenever a benefit crystallisation event (BCE) occurs.  In broad terms, this means when a person crystallises his or her pension savings.  This might be the commencement of a final salary pension, the purchase of an annuity from a defined contribution pension scheme, the conversion of a pension scheme to a drawdown arrangement or the payment of lump sum death benefit.  All of these are points at which the pension scheme starts to pay out the benefits under the scheme rules.

The tax rate can be either 25% or 55% depending on the type of BCE.  The very penal rate of 55% generally applies to lump sum withdrawals while the 25% rate generally applies to pensions and annuities.

Example

A person with no other pension entitlements who receives a pension of £40,000 and a pension commencement lump sum of £280,000 under a defined benefit scheme will be subject to the LAC.  This is because the value of the pension will be £800,000 (using a factor 20 applied to the pension of £40,000) and so the total value of the benefits is £1,080,000.  The excess of £80,000 will be subject to the LAC either at 25% or 55%.

In this situation the pension scheme member is entitled to a tax-free amount pension commencement lump sum of £250,000 so that £30,000 will be taxed at 55% and the remainder of the £80,000 excess will be taxed at 25%.  Therefore the LAC will be (£30,000 x 55%) + (£50,000 x 25%) = £29,000.

How to avoid or reduce the LAC

To a large extent the LAC is difficult to avoid because it depends on the success of the pension scheme investments.   The LAC can be regarded as the price of success.

However, whenever the Government have reduced the lifetime allowance they have introduced reliefs for pension scheme members who might otherwise be disadvantaged by the change in rules.  Broadly speaking, pension scheme members are given the opportunity to apply to protect the lifetime allowance before the rules were changed.

At the time of writing (September 2016) the protections which are still available to taxpayers are as follows:

1. Individual Protection 2016 (IP 2016) 

This is available to pension scheme members whose pensions were worth more than £1 million 5 April 2016.  It allows a person to retain a lifetime allowance equal to the lower of:

• the value of the pensions at 5 April 2016; and
• £1.25 million.

A person who has applied for IP 2016 can continue to build up pension savings but clearly might be subject to the LAC on pension savings in excess of the protected lifetime allowance.

2. Fixed Protection 2016 (FP 2016)

This fixes the lifetime allowance at £1.25 million but, unlike IP 2016, generally no further pension savings can be made.

3. Individual Protection 2014 (IP 2014)

This is similar to IP 2016 and is available to pension scheme members whose pensions were worth more than £1.25 million 5 April 2014.  It allows a person to retain a lifetime allowance equal to the lower of:

• the value of the pensions at 5 April 2014; and
• £1.5 million.

It is worth noting that a person can still apply for IP 2014 up to 5 April 2017.

Final comment

All of these different ‘protections’ subject to various terms and conditions.  It is recommended that specific advice be taken in all circumstances.