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Unforeseen consequences of booming stock markets

When it comes to pensions, rising stock markets aren’t always a good thing.

On the face of it, seeing many stock markets around the world including the FTSE100, standing at higher levels than 12 months ago can only be good news for people whose pensions depend on the performance of equity markets.

As stock markets recovered from lows in early 2020, many with defined contribution pensions whose value depends on the ups and downs of the stock market will have seen the size of their pension pots rise significantly.

But hold on, not so fast. Could the recovery in the markets, which has seen the FTSE100 rise from a closing price of 6,067.76 on 26 May 2020 to 7,026.93 as of close of trading on 26 May 2021 deliver an unexpected surprise in the form of a tax charge?

While a bigger pension pot is at first glance a good thing, the risk is that individuals, who may have spent many years paying relatively modest amounts into their pension funds could unwittingly fall foul of the Government’s Lifetime Allowance charge, leaving them with an unforeseen tax bill.

What is the Lifetime Allowance?

The Lifetime Allowance was introduced in 2006 and sets the limit an individual can accumulate in their pension fund while retraining the full tax benefits. This was set initially at £1.5m, but after increasing to £1.8m it has steadily been reduced and for the 2021-2022 tax year it is £1,073,100. In the Spring Budget, the Chancellor announced that it would be frozen at this level until 2026 at the earliest.

What are the consequences of breaching the Lifetime Allowance?  

If an individual’s fund exceeds the Lifetime Allowance the excess over and above the Allowance will be subject to an additional tax charge.

  • If they draw the excess amount as a lump sum it will be taxed at 55% with the individual receiving the remaining 45%.
  • If the individual leaves the excess in their pension fund, it will be taxed at 25%.

To take an example, if an individual’s pension fund was valued at £1,250,000 it would be subject to a tax charge up to £97,295, as set out below:

LTA                                         £1,073,100

Excess Benefits Value            £176,900

Lump Sum           £176,900 taxed at 55%  = Additional tax charge of £97,295

Retained              £176,000 taxed at 25% = Additional tax charge of £44,225

It would be easy to believe that a Lifetime Allowance of more than £1m would affect only a relatively small number of people. However, research by Royal London found that 290,000 non-retired people had already built up pension rights in excess of their Lifetime Allowance, while 1.25m non-retired people can expect to breach the Allowance by the time they retire.

 A Lifetime Allowance tax charge is not inevitable

While the prospect of breaching the Lifetime Allowance is something that few people will welcome, the good news is that it is not inevitable, and under certain conditions it is possible to protect a pension pot from the Allowance.

First, perhaps unbeknown to them, individuals may already have this protection in place. And even if they don’t have this built-in protection, there a couple of ways they may be able to draw benefits from their pension without incurring additional tax charges:

  • Individual Protection 2016, which fixes the Lifetime Allowance to the lower of £1.25m or the value of an individual’s fund at the 5th April 2016.
  • Fixed Protection 2016 – Fixes the Lifetime Allowance at £1.25m provided neither the individual nor their employer have added to the fund since 5th April 2016.

If you would like to know more or think this could affect you, please contact your Courtiers Adviser. It is better to act now than face an unwelcome surprise when you come to draw benefits from your pension fund.

Important Information

Tax treatment depends on individual circumstances and may be subject to change in future.

The views expressed by Courtiers in this summary are reached from our own research. Couriers cannot accept any liability for any decisions taken as a result of reading this article. Investors are recommended to take independent professional advice before effecting transactions and the prices of stocks, shares and funds, and the income from them can fall. Past performance is not a guide to future returns.

We do not endorse or accept responsibility for website content on any websites other than those operated by Courtiers, which may be accessible via links in this article.

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