For most people, pensions are the best way to save for retirement, thanks to generous tax relief and tax-free growth over the long term. You can use our guide to find out how much you need to save into a pension to ensure you have enough money when you need it.
However, there’s a limit to how much you can save into pensions. There is a cap on how much you can contribute to a pension in a single year (your annual allowance), and also a limit to how much you can draw out of pensions in your lifetime (your lifetime allowance). Although both limits are generous, higher earners and some self-employed people may run the risk of exceeding either or both.
Your annual allowance
The most you can pay into pensions in a single tax year, and still receive tax relief, is either £40,000 or 100 per cent of your qualifying earnings (whichever is lower). It may sound odd to pay your entire earnings into a pension, but it can happen (for instance if you have savings). It is also a common pitfall for company directors, who may take most of their income as dividends, with only a small salary. Dividends don't count as 'relevant UK earnings' for this purpose, so the maximum annual pension contribution would be equal to the (small) salary.
If you exceed this allowance, you won’t receive tax relief on the excess, and you will also have to pay an annual allowance charge. However, you can carry forward any unused annual allowance from the past three tax years. Your financial adviser can tell you more about this.
If you have started to access your pension pots, but want to keep paying money into them, then be aware that your annual allowance will shrink to £4,000 for all defined contribution schemes you're in, and £36,000 for all defined benefit schemes. Find out more about the annual allowance.
Your lifetime allowance
You can draw a maximum £1,073,100 from pensions in your lifetime without triggering an extra tax charge. Note that the allowance is defined as the amount you draw out – but in practice it helps to think of it as a limit on how big you can let your pension pots grow.
If you tend to pay a lot into pension schemes, it is possible to exceed the allowance without meaning to. Your pots may grow by more than expected, or you may be automatically enrolled in a new pension scheme when starting a new job. It is even possible to exceed the allowance when you die – some death-in-service benefits are set up to pay directly into the pension scheme itself.
If you exceed the lifetime allowance, any excess will be taxed at 25 per cent if taken as income, or at a hefty 55 per cent if taken as a lump sum.
How do I work out my lifetime allowance if I have a final salary scheme?
Final salary (defined benefit) pension schemes don't build up a fixed pot of money, so you can't see at a glance how much of your lifetime allowance they use up. Instead, you need to look at how much income the pension will pay per year, and multiply this figure by 20. So if your final salary pension is due to pay £10,000 a year, it will 'use up' £200,000 of your lifetime allowance. By this calculation, you can see that a final salary pension paying £52,750 a year would use up your entire lifetime allowance, leaving you subject to extra tax charges on any pension income over this limit.
A financial adviser can alert you if you are at risk of exceeding either allowance.