How to avoid the 55% pension lifetime allowance savings trap

Young workers and middle-class savers could be hit by a 55% tax charge when they retire, thanks to a reduction in what's known as the pension lifetime allowance.

The lifetime allowance has been reduced twice since April 2012, instead of rising in line with inflation (rising prices). In 2006, a lifetime allowance was introduced at £1.5 million, rising each year to reach £1.8 million in 2010. For the 2012/13 tax year, the lifetime allowance was cut by £300,000 to £1.5 million and then lowered by £250,000 to £1.25 million in this tax year (2014/15).

This lifetime allowance applies to the total value of all your pension pots, including any defined-benefit (final-salary) workplace pensions, but excluding the State Pension. When this total value exceeds the current limit of £1.25 million, you will pay tax on all savings that exceed this cap. If taken as income, this excess is taxed at 25%. If taken as a lump sum, the punitive 55% tax rate applies.

You could face this 55% tax

Although £1.25 million would buy most of us a generous retirement income today, remember that this ceiling is in today's terms. In, say, 25 years, inflation will dramatically erode the monetary value of the cap, dragging millions of today's young workers and older savers into this 55% tax trap.

When first introduced, the lifetime allowance affected only a few thousand of the highest paid, mostly in the top 1% of earners. But cutting the cap twice has brought more pension savers into the loop. HM Revenue & Customs (HMRC) calculates that the reduction to £1.25 million in 2014/15 hit 360,000 workers and savers. In addition, plunging annuity rates have vastly increased the value of final-salary pension pots, pulling thousands more workers into this tax trap.

What's more, according to calculations by pension provider Zurich, the rising cost of living is set to give current and future workers an even bigger headache. Zurich calculates that, assuming inflation of 2% a year and a cap frozen at £1.25 million, the value of the lifetime allowance in 25 years' time will be under £762,000 in today's money. This would buy a pension worth just over £19,800 today, which is hardly a king's ransom worth taxing at 55%.

Essentially a tax designed to soak the super-rich will drag millions of middle-class workers and savers into its net.

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Scrap the cap

The pensions minister Steve Webb has said that he wants to scrap the lifetime cap entirely, through reform of tax relief on pension contributions.

At present, pension contributions attract tax relief at a worker's marginal tax rate of 20%, 40% or 45%. By reducing tax relief to a flat 33.3% (£1 of relief for every £2 paid in), Webb believes that the lifetime cap could be raised or even scrapped altogether.

What you can do to avoid this 55% tax

The main way to avoid the tax is to pay less into personal pensions and redirect these savings into other tax-efficient vehicles. If you are in a final-salary pension scheme, then leaving this scheme or ceasing or lowering your contributions is usually a huge mistake, thanks to the enormous value of the guaranteed benefits on offer.

On the other hand, if you are in a defined-contribution occupational scheme or contribute to a personal pension, then you could decide to stop paying in so much, or even completely cease your contributions.

If you are worried about this 55% tax trap and have monthly savings to spare, then probably the best place to build up an additional tax-free pot for retirement would be inside an ISA. You can contribute up to £15,000 into an ISA this tax year and use this cash to earn interest or buy shares or other assets. All interest, income and capital gains made inside ISAs are free of tax.

For seriously well-heeled workers already paying the maximum into pensions and ISAs, other tax shelters are available. However, these schemes - such as Venture Capital Trusts (VCTs) and Enterprise Investment Schemes (EISs) - are complex and illiquid, making them suitable only for experienced investors.

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