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The annual and lifetime allowance for pensions explained

The pensions annual allowance and lifetime allowance limit how much people can take advantage of tax relief on their retirement pots and have hit the headlines due to recent changes. 

We explain the allowances and what they mean for you.

New annual limits explained: How much can YOU save into your pension tax free?

Everyone is allowed to save for retirement out of untaxed income up to a pretty generous level every year, including the highest earners.

That is the underlying principle of pension tax relief, and is the key thing to remember before you start looking at all the allowances and rules that come attached to it.

How pension tax relief works is that you receive rebates, or a top-up from the Government paid into your pension, based on your income tax rate of 20 per cent, 40 per cent or 45 per cent.

These take you back to the position you were in before income tax. 

But there are limits placed on how much you can save without incurring a penalty, though the annual rules were made much more generous in the last Budget – and the current lifetime cap of around £1.1million will be scrapped from April 6 2023.

The full rundown of Budget changes for pensions is here, and below we explain how the system works now and after the new rules take effect.

What is the annual allowance?

The annual allowance is the standard amount you can put in your pension every year and qualify for tax relief on what you saved.

It is currently £40,000 , or up to 100 per cent of your annual earnings if they are lower than this, but will rise to £60,000 or your earnings level from April 6.

The annual allowance includes your own and your employer’s contributions into a pension, and the tax relief itself.

The rules are more complicated for higher earners, whose annual allowance was previously tapered down to as little as £4,000, but this will be changed to a more generous £10,000 from 6 April.

The annual allowance starts being tapered down for people with an adjusted income level – which includes pension contributions – of £260,000.

It is reduced by £1 for every £2 of ‘adjusted income’ above that figure, but only down to the new amount of £10,000.

The threshold income level, where people’s annual earnings start being calculated for the purposes of pension tax relief, is £200,000.

What are the time limits on using the annual allowance?

One very important perk of the annual allowance is that you can still benefit from any of it left unused over the three previous tax years, under certain conditions.

You need to have been a member of a pension scheme during the years you intend to ‘carry forward’ annual allowance from, although you don’t need to have paid anything into it.

That often catches out people, such as the self-employed, who have neglected retirement planning and are trying to build up a pension from scratch.

You must also use up your entire annual allowance first for the year in which you want to do carry forward, and you have to go back to the earliest of the three years and use up the allowance from then first.

What are defined contribution and final salary pensions?

Defined contribution pensions take contributions from both employer and employee and invest them to provide a pot of money at retirement.

Unless you work in the public sector, they have now mostly replaced more generous gold-plated defined benefit – or final salary – pensions, which provide a guaranteed income after retirement until you die. 

Carry forward has become even more valuable now the lifetime allowance is being axed, because if you can afford to you can play catch-up with your savings to an even greater extent.

It is often used by people who become much higher earners later in life, or who inherit money and want to save it tax efficiently, and perhaps want to pass on their defined contribution pensions free of inheritance tax too.

Beneficiaries either pay no tax on what is left over in a defined contribution pension scheme if the owner dies before age 75, or their normal income tax rate if they are 75 or over.

What if you go over the annual allowance?

This is not illegal, but you will effectively not get any tax relief on any excess pension contribution, because that amount will be added to your taxable income and subject to income tax.

This is known as the annual allowance charge.

You can check with your pension provider whether it it will allow you to use a ‘Scheme Pays’ system, which means the charge would come out of your pension instead.

It is also possible to use carry forward to wipe out or mitigate the charge. 

What is the ‘money purchase annual allowance’ or MPAA?

This allowance is intended to put people off recycling their pension withdrawals back into their pots to benefit from tax relief twice.

It stops anyone who has made a withdrawal, over and above their 25 per cent tax free lump sum, from benefiting too much from valuable tax relief on contributions from then onward.

The new reduced annual allowance savings limit has stood at £4,000 since 2017, but it will be raised to £10,000 from April 6.

Pension industry experts argued the lower figure was a barrier to retirement saving for people who want to return to work and boost their pensions while doing so.

The MPAA was originally £10,000 when it was introduced in 2015, alongside pension freedoms that made it much easier to tap pensions from the age of 55.

What does the scrapping of the lifetime allowance mean for you?

Chancellor Jeremy Hunt is ditching the £1,073,100 total limit people can have in their pension pot without facing tax penalties from April 6.

He was expected to increase the limit to £1.8million rather than abolish it outright, so this was an eyecatching but controversial move to keep higher earners in the workforce.

Labour has promised to reinstate the lifetime allowance if it wins the next election, which should be borne in mind if this could affect your retirement plans.

The lifetime allowance includes both the money savers and their employers have paid into pensions and any growth over the years.

As with the annual allowance, you can keep saving above it but you face charges which claw back any tax relief – a 25 per cent charge on income, and 55 per cent on a lump sum.

Pension experts predict a flood of new money into pensions from the better off, but caution that you should seek professional advice to avoid any pitfalls.

If you have that amount stashed in a pension already it is sensible to pay for financial advice especially regarding how the carry forward rules might affect you, and any ‘fixed protection’ which allowed people to freeze their LTA at older, higher limits as long as they stopped making further contributions.

There is also the issue of the 25 per cent tax free lump sum, which has been capped at £268,275 – a quarter of the current LTA limit – unless you have fixed protection in which case the higher figure can apply, even if you start paying into your pension again.

When the lifetime allowance was introduced by Labour in 2006 it was £1.5million, but this was gradually raised to reach £1.8million in the 2010/2011 tax year.

However, it was then slashed by Conservative Chancellors George Osborne and Philip Hammond, falling all the way down to £1million in 2017/2018, before being moved gradually up again.

If the lifetime allowance had risen in line with inflation since 2006 it would now stand at £2.66million, according to This is Money’s inflation calculator.

For someone with a defined contribution pension kept invested and drawn on at a standard rate of 4 per cent annually, the current lifetime allowance equates to an income of £43,000.