Higher earner? Time to protect your pension

In April 2016 the new Finance Act will come into effect, and the outlook for mid-to-higher earners is stormy. Limits on the amount you can save into your pension mean a lot of money could be swept away by a huge tax bill – not just once but three times over.Y01VDYAX63

Is your pension pot close to overflowing? It might sound like a nice problem to have – but it’s anything but. This April, some pretty draconian legislation comes into effect that will seriously limit the amount you can build up in your pension – and if you exceed these limits, then you could lose much of that money in tax or suffer other costly restrictions.

If your annual income is in the region of £80,000 or over, the two hazards you need to be aware of are:

  • The tapered annual allowance
  • The reduced lifetime allowance

There’s also an additional hazard relating to death-in-service benefits. We’ll cover them in order.

Threat 1: The tapered annual allowance

Your annual allowance is the amount that can be paid into your pension each tax year and still receive tax relief on it. This is currently £40,000 and includes both your own contributions and any that your employer (or anyone else) may make. However, from 5 April 2016 the allowance will progressively reduce (‘taper’) for people whose adjusted income is over £150,000. For every £2 over this figure that you receive in adjusted income, your annual allowance will reduce by £1. The maximum reduction is £30,000, which means that if your adjusted income is £210,000 then your annual allowance will reduce to just £10,000.

Hang on – what does ‘adjusted’ income mean?

This is a crucial point. You may still be affected if your actual salary is less than £150,000. Other factors are included when working out your adjusted income, such as employer pension contributions, income from property, dividends, taxable interest on savings and any other taxable income. All this can lift you over the £150,000 mark and trigger a reduced annual allowance. You’re only safe if your actual salary is below £110,000, in which case it doesn’t matter what your adjusted income amounts to.

The risk here is the uncertainty over whether your adjusted income will be ‘over the limit’. Things such as pay rises, bonuses and dividend payouts could all catch you by surprise – and if you run your own business things are even more uncertain, since you won’t know your final profits until the year end.

What can I do?

If you think your annual allowance may be reduced as a result of your adjusted income being too high, you should:

  • Maximise your contributions before April – using any unused allowance from previous years (you can go back up to three years)
  • Talk to a financial adviser about other options (for instance, you may be able to reduce your adjusted income through arrangements with your employer).

Threat 2: The reduced lifetime allowance

Your lifetime allowance is the total amount you can withdraw from pensions (i.e. all your pension pots collectively). That is, there is nothing to stop you accumulating more pension savings than this – but when you come to draw the money out, anything over the lifetime allowance will be taxed at 55 per cent (if you take it as a lump sum) or 25 per cent (if you take it any other way).

From 5 April 2016, the lifetime allowance drops sharply from £1.25 million to £1 million, potentially exposing many more people to these high tax charges. Note that the £1 million figure refers to the value of your pension at retirement – not the value it might be at the time the change comes in. This means that anyone with an income of around £80,000 or higher could potentially exceed the allowance by the time they retire.

How can I tell if I might go over the limit?

Good question – this can be hard to calculate, especially if you have some years to go before retirement. Remember that all your pensions go into making up the total, not just your current one. With defined contribution (money purchase) pensions, it’s tricky to guess how much they might grow between now and then, whereas defined benefit (final salary) pensions need to be calculated in a different way, as they don’t involve a pot of money at all.

What can I do?

The best person to help you work out your position is a financial adviser who specialises in pensions. If you tell them you’re worried about the lifetime allowance, they will know exactly what kind of help you need. They can calculate the the current value of all your pensions, project the likelihood of you exceeding the limit, and recommend actions you can take to keep your pension savings below the threshold (while offering other potential options for any excess money).

You can also apply for protection to increase your annual allowance – the available options are Fixed Protection 2016 and/or Enhanced Protection 2016. Your adviser can tell you more about these.

Threat 3: Death-in-service benefits

This is really an additional complication of the reduced lifetime allowance (see above). If you die, your employer will typically pay out death-in-service benefits (usually 4x your salary) – and these payments are generally included as part of your pension pot.

By now you will have realised that this could lead to a very unpleasant surprise. You may have seen that your pension savings are comfortably below the lifetime allowance – but then, close to retirement, you die. If your salary was £80,000 then your death-in-service benefits would be £320,000, which could lift your total savings over the threshold and end up being heavily taxed. Your family would then receive a greatly reduced payment – potentially less than half of what you assumed they would get.

What can I do?

Again, talk to your adviser about managing the size of your pension savings and applying for protection if possible.

Find your financial adviser today at unbiased.co.uk.