The annual and lifetime allowance for pensions explained

The annual allowance and the lifetime allowance for pensions limit how many people can take advantage of tax relief on their pension pot and have been in the news due to recent changes.

We explain what the surcharges are and what they mean for you.

Everyone is allowed to save up to a fairly generous level each year for retirement from untaxed income, even the highest earners.

That is the starting point of the pension deduction and the most important thing to remember before you look at all the allowances and rules that come with it.

How retirement tax credit works is that you receive rebates, or a supplement from the government that goes into your retirement, based on your income tax rate of 20 percent, 40 percent, or 45 percent.

These will take you back to the pre-income tax situation.

But there are limits to how much you can save without incurring a penalty, although the annual rules have been made much more generous in the latest budget – and the current lifetime limit of around £1.1m will be dropped from 6 April 2023.

The full overview of budget changes for pensions can be found here, and below we explain how the system works now and after the new rules come into effect.

What is the annual fee?

The annual supplement is the standard amount that you can contribute annually for your pension and that you can deduct for tax purposes on what you save.

It’s currently £40,000, or up to 100 per cent of your annual income if it’s lower, but will rise to £60,000 or your income level from April 6.

The annual allowance includes your own and your employer contributions for a pension and the tax reduction itself.

The rules are more complicated for higher earners, whose annual allowance was previously reduced to just £4,000, but this will be changed to a more generous £10,000 from April 6.

The annual allowance is phased out for those with an adjusted level of income – including pension contributions – from £260,000.

It is reduced by £1 for every £2 of ‘adjusted income’ above that figure, but only up to the new amount of £10,000.

The threshold income level, where people’s annual income starts to be calculated for the purposes of pension tax relief, is £200,000.

What are the terms for using the annual fee?

A very important advantage of the annual fee is that under certain conditions you can still benefit from what has not been used in the three previous tax years.

You must have been a member of a pension scheme in the years from which you want to ‘transfer’ the annual supplement, but you do not need to have paid anything for it.

This often surprises people, such as the self-employed, who have neglected pension planning and are trying to build up a pension from scratch.

You must also first use up your entire annual allowance for the year in which you want to settle and you must go back to the earliest of the three years and use up the allowance from that moment onwards.

Carryover has become even more valuable now that the lifetime benefit is being abolished because if you can afford it, you can catch up on your savings even more.

It is often used by people who earn much more later in life, or who inherit money and want to save it tax-efficiently and perhaps also want to pass on their defined contribution pension free of inheritance tax.

Beneficiaries either pay no tax on what remains in a defined contribution pension plan if the owner dies before age 75, or their normal income tax rate if they are 75 or older.

What if you go over the annual allowance?

This is not illegal, but you do not actually get a tax credit on any excess pension contribution, because that amount is added to your taxable income and subject to income tax.

This is called the annual allowance.

You can check with your pension provider whether you are allowed to use a Scheme Pay system, whereby the costs come from your pension.

It is also possible to use carry forward to cancel out or reduce costs.

What is the ‘money purchase annual fee’ or MPAA?

This surcharge is intended to deter people from putting their pension withdrawals back into their pot and enjoying double tax benefits.

It prevents anyone who has made a withdrawal, on top of their 25 percent tax-free lump sum, from benefiting too much from valuable tax relief on contributions from then on.

The new reduced annual allowance saving limit has been £4,000 since 2017, but will be increased to £10,000 from 6 April.

Pension industry experts argued that the lower figure was a barrier to retirement savings for people looking to return to work while increasing their pensions.

The MPAA was originally £10,000 when it was introduced in 2015 alongside retirement freedoms that made it much easier to tap pensions from age 55.

What does the abolition of the lifelong supplement mean for you?

Chancellor Jeremy Hunt is scrapping the £1,073,100 aggregate limit people can have in their pension pot from April 6 without facing tax penalties.

He was expected to raise the cap to £1.8 million rather than abolish it altogether, so this was a high-profile but controversial move to keep higher earners in work.

Labor has promised to reinstate the lifetime benefit if it wins the next election, which you should consider if this could affect your retirement plans.

The lifetime benefit includes both the money savers and their employers who have paid into pensions and any growth over the years.

As with the annual allowance, you can continue to save above that, but you’ll incur costs that will reclaim any tax credits — a 25 percent levy on income and 55 percent on a lump sum.

Pension experts predict a flood of new money into the pensions of the wealthy, but warn that you should seek professional advice to avoid any potential pitfalls.

If you’ve already put that amount into a pension, it’s wise to pay for financial advice, especially regarding how the transfer rules affect you, and any “fixed protection” that allowed people to freeze their LTA against older, higher limits , as long as they stopped making further contributions.

There’s also the issue of the 25 per cent tax-free lump sum, which is capped at £268,275 – a quarter of the current LTA limit – unless you have firm protection, in which case the higher amount may apply even if you start paying again in your pension.

When introduced by Labor in 2006, the lifetime allowance was £1.5 million, but this was gradually increased to £1.8 million in the 2010/2011 tax year.

However, it was subsequently cut by Conservative Chancellor George Osborne and Philip Hammond, falling all the way to £1m in 2017/2018, before gradually rising back up.

If the lifetime benefit had risen in line with inflation since 2006, it would now be £2.66 million, according to This is Money’s inflation calculator.

For someone with a defined contribution pension that is invested and withdrawn at a standard rate of 4 per cent per annum, the current lifetime benefit equates to an income of £43,000.