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Pensions Tax Manual

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The lifetime allowance and the lifetime allowance charge: reduced lifetime allowance

Glossary PTM000001
   

 

Where an individual’s lifetime allowance is reduced 
Pensions in payment that started before 6 April 2006 
Protected pension age below age 50 at 6 April 2006 
Information to be provided to the member where the member has reduced lifetime allowance

Where an individual’s lifetime allowance is reduced

Sections 218(6) and 219(8) and paragraphs 19 to 21 Schedule 36 Finance Act 2004

There are two circumstances where a member’s available lifetime allowance at a particular benefit crystallisation event (BCE) will be reduced.

These are where a member:

  • becomes subject to their first BCE, and has any pension in payment which started before 6 April 2006 (a pre-commencement pension), or
  • draws benefits before age 50 under a registered pension scheme because they have a protected pension age.

Pensions in payment that started before 6 April 2006

Where a member is in receipt of a pension that came into payment before 6 April 2006 the level of lifetime allowance the member has available is reduced the first time a BCE test is triggered on or after 6 April 2006. The level of this reduction is based on the value of that pension in payment immediately before that BCE.

This is explained at PTM088300.

Protected pension age below age 50 at 6 April 2006

In certain circumstances, a member may have a right to a protected pension age if they had a right on 5 April 2006 under their scheme rules to draw benefits before the normal minimum pension age - see PTM062220. Where a member has a protected pension age of less than 50 under a registered pension scheme there is a knock-on effect for lifetime allowance purposes where they exercise that right.

Where the member draws benefits before 50, their level of lifetime allowance must be reduced by what is called the relevant percentage (see guidance below). This is because the crystallised value for lifetime allowance purposes of any benefits drawn will not adequately reflect the true capital value of that benefit, as it has been drawn so early in the individual’s lifetime.

For example, the crystallised value of a £20,000 per annum scheme pension for lifetime allowance purposes is £400,000, whether it is paid to a member at age 40 or age 60. However, the cost of securing a pension starting at age 40 is far greater than the cost of securing the same pension payable from age 60 (as the pension payable from age 40 will be potentially payable for much longer). So the true capital value of that pension is far greater.

The level of the individual’s lifetime allowance is therefore reduced to reflect this early payment. This means that the percentage of the lifetime allowance that the crystallisation of the scheme pension uses up will be correspondingly increased.

If for example the individual’s lifetime allowance would normally be £1.25 million at this point, and the relevant percentage is 25 per cent, the individual’s lifetime allowance will be reduced to £937,500. Using the example above, the £400,000 crystallising in relation to the scheme pension coming into payment at 40 will therefore use up 42.66 per cent of the individual’s lifetime allowance, rather than only 32 per cent if compared to the normal lifetime allowance entitlement.

A reduction by the relevant percentage is only applied where a BCE occurs in relation to the arrangements in the registered pension scheme where that right is held, and only where those benefits are actually drawn before the normal minimum pension age.

This reduction does not apply where an individual retains the right to draw benefits before age 55 because of existing rights held on 5 April 2006, but where that protected pension age is 50 or higher.

Relevant percentage

Paragraphs 19 and 23A Schedule 36 Finance Act 2004

The earlier the benefits are paid before the normal minimum pension age, the higher the relevant percentage will be. So the earlier the benefits are drawn, the more lifetime allowance will be used up.

The individual’s lifetime allowance will be reduced by 2.5 per cent for each complete year between the date on which the BCE occurs and the date on which the individual will reach age 55. So for an individual with a protected pension age of 35 who takes benefits on their 35th birthday there are 19 complete years between their 35th birthday and age 55. The reduced lifetime allowance alters the individual’s available lifetime allowance both for the purposes of calculating whether any lifetime allowance charge is due and in terms of the maximum pension commencement lump sum payable.

Where the individual has a subsequent BCE and the amount crystallised at the earlier event exceeded the amount of the individual’s lifetime allowance at that time, an adjustment must be made to the amount of the individual’s lifetime allowance used up by the first benefit crystallisation event.

Enhanced lifetime allowance

The same principle applies if the member is entitled to an enhanced lifetime allowance. The reduction is simply applied to the enhanced level of lifetime allowance, rather than the standard lifetime allowance. An individual’s lifetime allowance will be calculated in the normal way, by reference to the standard lifetime allowance and any lifetime allowance enhancement factors. The scheme administrator will then reduce the resulting lifetime allowance figure by the appropriate relevant percentage.

Example of the effect of the reduction of the lifetime allowance where a member takes benefits before normal minimum pension age

Boris has a protected pension age of 35. In 2006-07, just after his 35th birthday, Boris takes pension rights with a capital value of £1 million. The normal minimum pension age is 50 and the standard lifetime allowance (which Boris has) is £1.5 million.

Boris’s lifetime allowance is reduced by 35 per cent - this is 2.5 per cent for each of the 14 complete years between the date of taking benefits and the normal minimum pension age. His lifetime allowance for these benefit crystallisation events is £975,000.

This reduced lifetime allowance also affects the amount that he can be paid as a pension commencement lump sum. The maximum lump sum Boris can receive is £243,750 (£975,000/4).

Boris is paid a lump sum of £243,750 with the remaining £756,250 being used to provide a pension. The value of the benefits paid, £1 million, is tested against the amount of his reduced lifetime allowance, £975,000. As the value of benefits taken exceeds the available lifetime allowance, there is a lifetime allowance charge on £25,000.

In March 2012, aged 40, Boris takes benefits valued at £500,000 from another scheme that also has a protected pension age. The standard lifetime allowance is £1.8 million in 2011-12. Boris’s personal lifetime allowance is reduced by 35 per cent for the 14 complete years between taking benefits and the normal minimum pension age of 55. His lifetime allowance at the second benefit crystallisation will be £1,170,000.

The value of Boris’s first BCEexceeded his available lifetime allowance at that time. So the value of the rights previously crystallised is taken to be the amount of his available lifetime allowance at that time, i.e. £975,000 not £1 million. The £975,000 deemed to have been taken at the first benefit payment is now worth £1,170,000 (as increased by £1.8/£1.5 million).

The maximum lump sum Boris can now have is £nil, being (£1,170,000 - £1,170,000)/4.

The value of the two benefit crystallisations (£500,000 + £1,170,000) is tested against the reduced lifetime allowance of £1,170,000. The value of benefits taken (£1,670,000) exceeds the available lifetime allowance (£1,170,000) so there is a lifetime allowance charge on £500,000.

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Information to be provided to the member where the member has reduced lifetime allowance

Regulations 7, 14 and 16 The Registered Pension Schemes (Provision of Information) Regulation 2006 - SI 2006/567

Paragraph 19(6) Schedule 36 Finance Act 2004

When benefits crystallise, the scheme administrator must provide the member with a statement detailing the percentage of the standard lifetime allowance used up by the BCE - see PTM164100. Where the member has a reduced lifetime allowance and the amount of benefits crystallised is more than the reduced lifetime allowance, the percentage of the standard lifetime allowance used up should be based on the amount crystallised at the BCE below the reduced lifetime allowance.