The rules on pensions have gone through some significant changes over the years. Here are the basics:
- Investors get income tax relief on their contributions into a pension scheme (up to certain limits – see below)
- The income and gains made by that fund roll-up free of additional tax whilst the money remains invested
- At retirement, you can take a tax-free lump sum of up to 25% of the total fund value
- The remainder of the fund is then used to provide an income or a lump sum which will be taxable at your marginal income tax rate
Annual contribution limits
The annual allowance is a limit on the amount that can be contributed to your pension each year, while still receiving tax relief. It’s based on your earnings for the year and is capped at £40,000.
What is the annual allowance?
The annual allowance is a limit to the total amount of contributions that can be paid to defined contribution pension schemes and the total amount of benefits that you can build up in defined benefit pension scheme each year, for tax relief purposes. The annual allowance is currently capped at £40,000 although a lower limit of £10,000 may apply if you have already started drawing a pension. The annual allowance applies across all of the schemes you belong to, it’s not a ‘per scheme’ limit and includes all of the contributions that you or your employer pay or anyone else who pays on your behalf.
The lifetime allowance applies to the total value of all private and work pensions (not state pensions) that you build up over your lifetime, including the investment growth you achieve. It is a limit on the amount of pension benefit that can be drawn from pension schemes – whether lump sums or retirement income – and can be paid without triggering an extra tax charge.
The lifetime allowance was introduced in 2006 at a level of £1.5 million. It then increased each year to 2010,when it reached a level of £1.8 million. Since 2010, there have been a number of pension reforms which have led to the lifetime allowance being reduced. Its current level in the 2017-18 tax year is £1,030,000.
While most people aren’t affected by the lifetime allowance, you should take action if the value of your pension benefits is approaching, or above, the lifetime allowance. As pensions are normally a long term commitment, what might appear modest today could exceed the lifetime allowance by the time you want to take your benefits. It may be necessary to take your pension early or stop contributing to the scheme/plan, even though you have not retired, to avoid your benefits exceeding the lifetime allowance. The test for the lifetime allowance is done each time you access a pension benefit.
Building a pension portfolio
Choosing a type of pension is important, but the contribution you make and your choice of underlying investments will have the greatest impact on your long-term wealth. The investment choice within pensions has evolved from the days of the traditional life office products with a selection of one or two balanced funds. Now, most pensions offer a sufficiently broad choice of investments for you to build a truly individual portfolio.