Why Removing the Pension Lifetime Allowance Isn’t All it is Cracked Up to Be

Sarah Wakefield, Business Development Manager, Oxford Capital  

The pension lifetime allowance was a cap placed on the amount held within a client’s pension and for those who reached and breached this limit the financial penalties were substantial. Prior to the budget there had been speculation about the allowance being increased but the news that it had been lifted came as a welcome surprise to many. 

However, the annual allowance, which limits the maximum amount that can be invested into a pension each year still applies, although this has increased from £40,000 to £60,000. While you can carry back this allowance, the rules on this are outside the parameters of this article. 

The initial reaction to this news was for those clients who were close to the lifetime limit or had breached it to consider further investment in their pensions. However, it is not quite that simple.  

When an investor retires part of the pension can be taken tax free. For those who have been around a long time, like me, this was referred to as the ‘tax free cash’ however is now referred to as the Pension Commencement Lump Sum (PCLS). In the Budget statement, it was also announced that the PCLS will be retained at £268,275 (ie 25% of the outgoing lifetime allowance) and will be frozen thereafter. Except for people who have a higher PCLS by way of protecting their previous higher lifetime allowance. Any pension paid out is then subject to income tax in the normal way. 

For most investors who are comfortably within the previous pension lifetime allowance the freezing of the PCLS may make little or no difference, as 25% of the funds they have accrued will not exceed £268,275.  

However, for clients who have reached or breached the limit, any funds accumulated over the capped PCLS will be caught by income tax when benefits are taken.  

Investors will still get the income tax relief on the way in, provided they are not exceeding the annual limits, and the growth within the pension fund is still tax efficient. However, when investors come to take their pension, the restriction on the tax-free element of PCLS will push the excess into income tax. Combine this with the recent freezing of income tax thresholds until April 2028 means the effective rate on the retirement income being taken is increasing. As an alternative, EIS offers a range of tax reliefs including income tax relief on the amount invested at 30%. This can be carried back to a previous tax year. Provided the EIS is held for at least three years any growth made on the EIS qualifying shares are also free of UK tax. 

There are other tax benefits that EIS can offer including capital gains tax deferral. If an investor has had a gain which has been subject to capital gains tax in the last three years or has one in the 12 months following the investment into EIS, then the capital gains tax liability can be deferred by investing into an EIS. 

Another tax advantage available on EIS investments is that they would normally qualify for business relief for inheritance tax purposes. By investing into trading companies that are unquoted after holding the shares for 2 or more years, and provided they are also held on death, the shares should be exempt from inheritance tax on the death of the investor (or their surviving spouse or civil partner)  

EIS investments, however, do come with investment risk and whilst some companies that qualify for EIS tax reliefs may fail, investors can have some downside financial protection by virtue of loss relief. Loss relief will allow investors to offset any investment losses against either income tax or capital gains tax liabilities. 

Case Study – 

Let’s look at Tony and Joe. They are twins that both have pensions up to the previous lifetime limit. They had previously stopped contributing into their pensions as they did not want to pay the surcharges for exceeding the lifetime limit. Now they are considering putting more in. They want to retire at 68 (they are currently in their mid 50s). 

Let’s say they have a £1million pension pot and they will buy an annuity at 68 that will give an income of £50,000 per annum. They are both already into the higher rate tax, so any top ups would be caught by either higher or possibly additional rate.  We can consider two different scenarios at this point, with EIS as a potential alternative to investing into a pension: 

This is obviously a very simplified case study, and doesn’t consider costs, investment time horizons, liquidity, risks, other tax considerations etc but it helps to demonstrate the need for careful consideration around investments and retirement planning showing that the removal of the pension lifetime allowance may not offer the benefits that investors immediately assume it will.