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How to navigate protection and the lifetime allowance

4 months ago

The lifetime allowance (LTA) is a general limit on the amount of benefits you can take from your pension schemes before you incur tax charges.

It was introduced in 2006/07 as part of the ‘A-Day’ pension simplification process, which ushered in new tax rules that applied to all types of pension.

The LTA was initially set at £1,500,000, rising incrementally to £1,800,000 in 2011/12.

HM Treasury then reduced it on three separate occasions – 2012, 2014 and 2016 – taking it down to £1,000,000 before it started being increased annually in line with inflation.

In a previous article, I looked at enhanced protection and primary protection. These were the two forms of LTA protection introduced in 2006.

In this article, we will complete the set by looking at the several forms of fixed protection and individual protection introduced at the subsequent reductions in the LTA.

Fixed protection

The first new form of protection was ‘fixed protection’, typically now called ‘fixed protection 2012’ (FP 2012), given the introduction of the later forms of fixed protection. This accompanied the reduction in LTA from £1,800,000 to £1,500,000.

It gave the member a protected LTA of £1,800,000, of which 25% could be taken as a tax-free lump sum.

There was no minimum fund value requirement, and members had to submit paper applications to HMRC by 5 April 2012. The member would then receive a certificate confirming their protection.

A member cannot hold FP 2012 if they already hold enhanced protection or primary protection.

Given that the LTA was reduced twice more after 2012, FP 2012 in hindsight has proved to be a very beneficial form of protection.

Example

Patrick has a SIPP that’s valued at £2,000,000. He wants to take the maximum tax-free cash lump sum and put the rest into drawdown.

He crystallises the entire scheme in the 2020/21 tax year under FP 2012. He opts to take the LTA excess as a lump sum.

The calculations are as follows.

£2,000,000 = benefits being crystallised

£450,000 = tax-free cash (£1,800,000 x 25%)

£1,135,000 = designated to drawdown (£1,800,000 – £450,000)

£110,000 = tax charge (£200,000 x 55%)

£90,000 = LTA excess lump sum (£200,000 – £110,000)

Losing the protection

In this respect, FP 2012 looks similar to enhanced protection.

The member will lose FP 2012 if they contribute to a defined contribution pension or if they accrue benefits in a defined benefit pension. In a world where automatic enrolment is a feature of any workplace, this is something to be alert to.

There are also a few transfer situations that can cause issues.

If a member transfers pension rights to a defined contribution scheme from either a defined benefit scheme or another defined contribution scheme, the protection will remain intact. If they were to transfer to a defined benefit scheme, it would be lost (although there are exceptions).

A member would also lose their protection if they set up a new pension scheme to receive a pension credit from a pension-sharing order on divorce. (This is not the case if they transfer the credit to an existing scheme.)

And it’s unclear from the legislation as to whether establishing a beneficiary’s drawdown fund when inheriting death benefits would revoke the beneficiary’s FP 2012.

In the event the member does lose their protection, they must notify HMRC within 90 days or they could be subject to fines.

Fixed protection 2014

Two years later, the LTA was reduced from £1,500,000 to £1,250,000, and ‘fixed protection 2014’ (FP 2014) was introduced.

As the name suggests, this was very similar in nature to FP 2012, and it gave the member a protected LTA of £1,500,000, which meant a maximum tax-free lump sum of £375,000.

The deadline for applications was 5 April 2014, and applicants received a paper certificate confirming their protection.

The revocation conditions for FP 2014 are the same as for FP 2012. A member cannot hold FP 2014 if they hold FP 2012, enhanced protection or primary protection.

Individual protection 2014

Also introduced in 2014 was ‘individual protection 2014’ (IP 2014).

If fixed protection was similar to enhanced protection, individual protection was similar to primary protection. (It’s unclear why individual protection was introduced in 2014 and not in 2012.)

Upon successful application, the member gained a protected LTA based on their fund value as at 5 April 2014, albeit capped at £1,500,000.

A member can hold IP 2014 alongside FP 2014, FP 2012 and enhanced protection but not alongside primary protection.

To apply for IP 2014, the member had to have a total fund value across all their pensions of at least £1,250,000 as at 5 April 2016, and there were different methods for attributing a capital value to different types of benefits, as we’ll come on to in a moment.

Example

Gina had a total fund value of £1,350,000 as at 5 April 2014. This gave her a protected LTA of £1,350,000.

Tina had a fund value of £1,650,000 as at 5 April 2014. This gave her a protected LTA of £1,500,000.

Here’s how pension rights were valued for IP 2014 purposes. (This is the same for IP 2016.)

Pre-2006 benefits in payment

The value is calculated by taking the annual pension amount as at 5 April 2014 and multiplying it by 25. For capped drawdown, you use the GAD maximum income amount.

It gets more complicated if the member has separately taken benefits under another scheme between 6 April 2006 and 5 April 2014.

In that situation, you take the annual rate of income payable from the pre-2006 benefits as at the date the member first took benefits post-2006.

You multiply it by 25, and then revalue it by multiplying it by £1,500,000 and dividing by the standard LTA in place at that time.

(Annual pension x 25) x (£1,500,000 / standard LTA)

Example

Tom started drawing his defined benefit pension in 2003. He also had a small personal pension from which he took benefits in the 2010/11 tax year.

The annual amount of Tom’s defined benefit pension in 2010/11 was £12,500.

(£12,500 x 25) x (£1,500,000 / £1,800,000)

(£312,500) x (0.83333) = £260,416

The defined benefit pension in payment was therefore deemed to have a capital value for IP 2014 purposes of £260,416.

Post-2006 benefits in payment

Any pension benefits taken from 6 April 2006 onwards will have been tested against the LTA.

For IP 2014 valuation purposes, you take the monetary amount of the benefits that were crystallised and revalue them in line with the change in standard LTA.

Amounts crystallised x (£1,500,000 / standard LTA at BCE)

Uncrystallised funds

These are more straightforward to calculate. For money purchase pension rights, it’s simply the capital value of those rights.

For defined benefits pension rights, you take the annual pension to which the member would be entitled and multiply it by 20. You then add the value of the tax-free lump sum to that figure.

In other words, you use the capital value you would use for LTA purposes if they were being crystallised on 5 April 2014.

Losing the protection

Unlike FP 2014, IP 2014 cannot be revoked by a contribution or by benefit accrual.

However, if the member’s fund is subject to a pension sharing-order on divorce, they will need to notify HMRC as their protected LTA will be reduced given that a chunk of funds have left their pension.

If the fund value is reduced below £1,250,000, they will lose their protection entirely. For this purpose, the value of the pension debit is reduced by 5% for each tax year that has elapsed since the 2013/14 tax year.

Fixed protection 2016

Two years on from 2014 and we had a further reduction in the LTA, meaning two new forms of protection.

‘Fixed protection 2016’ (FP 2016) works the same way as previous versions, albeit the protected LTA is £1,250,000 and the maximum tax-free lump sum is limited to 25% of that.

However, there are a couple of differences. Firstly, the application is made online meaning no paper certificate is provided. HMRC instead gives members a protection reference number that they can give to their scheme administrator. Secondly, no deadline for applications has been announced.

That second point is more significant than it first seems, as there could be situations where the member has applied for FP 2016 having taken benefits from their pension after 5 April 2016 but before the submission of their FP 2016 application.

In that situation, it’s worth noting that FP 2016 takes effect from 6 April 2016 regardless of when the application was made, which means previous benefits calculations may have to be revisited.

In terms of revoking FP 2016, the same conditions apply as for FP 2012 and FP 2014. A member can hold FP 2016 alongside any form of individual protection but not alongside any other protections.

Individual protection 2016

The other form of protection introduced in 2016 was ‘individual protection 2016’ (IP 2016).

This is very similar to IP 2014, and a member can apply if they had a fund value as at 5 April 2016 of £1,000,000 or more. The valuation methodology is the same as for IP 2014.

In terms of benefits, IP 2016 gives the member a protected LTA based on their pension fund value as at 5 April 2016, capped at £1,250,000. The maximum PCLS is 25% of the protected LTA.

As with FP 2016, the application is made online, and no deadline has been announced. Again, this can be revoked if a pension-sharing order reduces the value of the pension rights below £1,000,000.

A member can hold IP 2016 alongside FP 2016 but no other form of protection.

This article was previously published by FT Adviser

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Martin Jones
Name

Martin Jones

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Technical Manager

After completing his postgraduate studies at Lancaster University, Martin spent two years working for a leading insurance company before joining AJ Bell in April 2007. Martin worked initially on the AJ Bell Investcentre product before moving to a technical role in 2009. His main focus is providing technical support to the various teams and departments within the business. He is also involved in delivering training to staff on the rules and regulations that affect our customers.

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