Is a £250k inherited pension counted in my lifetime allowance?

I was widowed in 2013. My late wife was a member of a company pension scheme and on her passing her pension company paid me approximately £250,000 from the fund.

I was given no choice as to whether it remained invested or not. She was in her 40s, still working, so had not benefited from her pension.

I am still working and well under my state retirement age of 67 and have not accessed any of my personal pensions – all defined contribution.

The pension company told me that my lifetime allowance would be reduced by the £250,000. At that time the LTA was £1.5million and my funds then were worth approximately £300,000.

The LTA is now reduced to £1,073,100 and my own funds are worth £950k and growing reasonably well.

As the LTA was lowered and has remained low, where does this leave me? How will I be assessed – against the £1.5million LTA when I benefited or against £1.073million now?

It seems most unfair if all withdrawals from my funds are measured against the new lower rate. Being wary of the current LTA I have resisted making further contributions so miss out on 40 per cent tax advantages.

Equally I haven’t accessed any funds in case the LTA rises in the next 16 years – or at least once in 2026 – and I want to pay more in whilst being wary of the annual allowance rules.

I don’t expect to live to 75 years, so if I don’t touch my funds under current legislation I can leave them to a nominated beneficiary tax free and outside of inheritance tax. Does my reduced LTA affect this at all? I understand the tax position should I make it to 75.

Steve Webb replies: The lifetime allowance is part of the system of pension tax relief which puts a limit on the value of the pension you can draw over the course of your lifetime whilst still enjoying the benefits of pension tax relief.

It’s not against the law to go over the LTA, but if you do so you face a tax charge. This is either 55 per cent on lump sum payments beyond the LTA or 25 per cent (over and above your standard income tax rate) on regular payments beyond the LTA.

As you say in your question, the level of the LTA can change from year to year. At one stage it was as high as £1.8million (back in 2010/11 and 2011/12) but has been repeatedly cut since then.

In 2020/21 it was set at £1,073,100 and the current plan is for it to stay at that level until the mid 2020s. 

The good news for you is that when you take money out of a pension – or ‘crystallise’ a pension to use the technical term – the value of that pension is tested against the LTA *in that year*.

In your example of taking a £250,000 pension in a year when the LTA was £1.5million, you would only be regarded as having used up one sixth, or 16.67 per cent of your LTA. This is regardless of the fact that the LTA is now lower.

You do however have less room for manoeuvre now that the LTA has been reduced.

As noted above, this year’s LTA is £1,073,100 and you have 83.33 per cent of your LTA left. This means that you could crystallise 83.33 per cent of £1,073,100 or around £894,000 in pension wealth without breaching the LTA.

Until recently, the Government has been using the LTA as a form of ‘stealth tax’, freezing the limit with the result that more people will face tax charges and/or that more people – like you – will opt to stop saving in a pension.

But there have been some rumours that the Government’s desire to get older workers back into the labour market *could* lead to an unexpected hike in the LTA.

Anyone thinking of cashing in their pensions this year might therefore want to think very carefully about doing so.

Did you miss out on a state pension lump sum if you were widowed?

 

This is Money’s columnist Steve Webb calls on elderly widows who might have missed out on a backpayment when their husbands died to get in contact. 

He wants to help people get money that is rightfully theirs, and find out if there is a systematic problem not picked up in the Government’s massive correction exercise for elderly women who were underpaid. 

Find out if you could be affected, and how to contact Steve here.

> Did you miss out on state pension if you were widowed in retirement? 

This is because any withdrawal this year will, as I’ve explained above, be tested against this year’s relatively low LTA.

If you used up your full LTA this year ( in your case, you withdrew £894,000) then you would be up to 100 per cent LTA usage.

As the rules currently work, even if the government raised the LTA next year, you would not benefit because you had hit the 100 per cent mark.

On the other hand, if you delayed until next year, the same withdrawal would be a smaller percentage of the new LTA if it had been increased by then, and that would mean you could withdraw extra pension money without incurring LTA charges.

I should stress that I cannot predict what will be in the Budget and it can be a risky business to make financial decisions based purely on speculation.

But if you think that the LTA is unlikely to actually fall next year, and there’s an outside chance it may rise, some may judge it is worth it to wait a few more weeks before tapping into some or all of their pension savings.

Finally, on your question about what would happen if you were to die before the age of 75, HMRC would regard your death (and passing on your untouched pensions to a beneficiary) as a ‘benefit crystallisation event’.

The value of your pensions would be tested against the prevailing LTA for that year and if the percentage used up took you over 100 per cent over your lifetime allowance then there would be a tax charge to be paid by your beneficiaries.