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The Spring Budget announced that the lifetime allowance (LTA) will be frozen at £1,073,100 until April 2026 at the earliest.

A prolonged period of no inflationary increases will mean that more and more clients may face LTA charges.

But it's important to remember that the LTA isn’t a ceiling on what can be saved into pensions. There are many good reasons why those potentially affected should continue saving into their pension in the new tax year, especially if stopping funding means losing out on contributions from their employer.   

The basic equation

Clients should only give up saving into their pension if there is a better alternative.

So if the net returns on pension savings (which could include employer contributions) are still greater than saving alternatives elsewhere then an LTA charge may be a price worth paying.

Any client faced with the prospect of exceeding their LTA has some difficult decision to make and the best course of action will depend on their individual circumstances:

• Should they give up their employer pension contributions?
• Does carrying on paying matching contributions make sense?
• If their employer offers extra salary in exchange for pension contributions will they be better off?
• Should they stop paying into their pension if this will lead to a tax charge on savings in excess of the LTA?

Important considerations

This table summarises what should be considered when making this important decision.

The loss of employer funding

Clearly, one of the key elements influencing choice will be the value of the employer contribution, which might also depend on the employee making contributions. Many employers offer matching contributions. So if your client stops funding, will their employer stop funding too?

Employer pension contributions are essentially 'free money'. Even if they suffer an LTA charge of 55% on their entire future employer funding, they should still be better off as they're receiving 45% of something they would otherwise miss out on. It may therefore make financial sense for most to continue their own funding to retain the funding from their employer, despite the LTA charge

Alternative employer remuneration package

The picture may change if the employer is prepared to offer additional salary instead of making pension contributions. It's a situation which can arise in the private sector, but unlikely to happen for public sector employees.

But much will depend on what the alternative offer is and the associated tax and NI on it. The employer may only be prepared to offer an amount which equates to the same net cost as the pension contribution (i.e. after employers NI liability).

For example, a higher rate tax paying employee receives an annual employer pension contribution of £40,000. After deduction of employer NI at 13.8%, that would equate to additional salary of £35,149. The employee then has income tax and NI to pay on the additional salary, so the amount they receive would be £20,386.

The question is then where to invest it?

• ISAs - generally the next best thing to pensions in terms of the tax advantages they enjoy. No tax relief, but fund growth is free of CGT and income tax and there's no tax when accessing the funds. The only real downside is that contributions are limited to £20,000 each year.
• Offshore Bonds - these enjoy the same tax free gross roll up as both pensions and ISAs. However, on surrender any gains will be subject to income tax.

• Mutual funds - these pay corporation tax on non-dividend income received within the fund. But clients may be subject to income tax on dividends or interest distributions and capital gains tax on investment growth.

The table below shows what the client might get back by investing the net pay of £20,386 over five years into another investment wrapper with the same gross roll up and achieving a 2.5% real rate of return. (This is for illustrative purposes as the net pay is greater than the current ISA allowance, but this could still be achieved by using a spouse's allowance).

* After LTA charge of 25% + 40% income tax on balance if taken as income
** After LTA charge of 25% + 20% income tax on balance if taken as income

This shows the difficulty of the decision faced. A key factor is the likely tax position of the client when funds are withdrawn. If pension income would all be taxed at higher rate, it's clearly better to take the extra salary and invest it elsewhere. But if income can be extracted from the pension at basic rate, then it swings more in favour of funding beyond the LTA even with the 25% tax charge. Other factors could also come in to play such as unused personal allowances, the starting rate band for savings and the personal savings allowance. Of course the availability of these will very much depend on individual circumstances.

Making personal contributions that result in an LTA charge

Funding above the LTA can make sense where it means retaining employer funding. But what about making personal contributions which will result in an LTA charge? There's something that feels slightly uncomfortable about paying contributions knowing that an additional tax charge will be applied. What really matters though is what clients will get back after all taxes have been deducted.

That will depend upon their rate of tax paid in retirement. If income in retirement can be kept at basic rate then personal contributions receiving 40% tax relief, even after the LTA charge, will achieve exactly the same return as an ISA (assuming the same investment returns).

The table below compares what the client might get back in their hand assuming a real rate of return of 2.5% over 10 years for the same net cost of £15,000.

So in this scenario, there is no difference between saving into a SIPP or an ISA. But add back in the net amount received from employer contributions and the SIPP will give a better return. There may be more to think about if the SIPP income is taxed at higher rate, but even then this might be outweighed by the ‘free money’ from the employer contribution.

In the above example, a higher rate taxpayer would pay an additional £4,800 in income tax when taking money above the LTA from their SIPP. But an employer contribution of at least £10,667 would make up for the additional tax on the personal amount saved: £10,667 -  (£10,667 x 55%) = £4,800.

But that's not the end of the story. On death the pension is generally IHT free, whereas both the ISA and offshore bond will form part of the estate for IHT, potentially being taxed by a further 40% on death.

Fixed Protection

Anyone who still has valid fixed protection will of course lose this if there are any new payments into their pension. This includes those who re-join their employer's auto-enrolment scheme, even if the employer pays all the contributions, or if they're enrolled into a new employer's scheme. This potential ‘cost’ must also be taken into account before any decisions are made.

Should a client re-start funding and perhaps benefit from their employer’s contribution? Or should they protect what they’ve got with fixed protection?

With the LTA frozen at £1,073,100 for the next five years, this could mean losing up to £176,900 of LTA protection for those who locked into a £1.25M LTA. But on the assumption that the LTA will continue to increase at CPI after the freeze, it should exceed the FP2016 amount of £1.25M by around 2032/33, at which point FP2016 will fall away. So much will depend on when clients expect to take benefits.

Remember the LTA charge only applies when benefits are taken in excess of the clients LTA amount (or at age 75) not necessarily when they first begin to take an income. If this date is close to or after the date when the standard LTA exceeds the fixed protection amount, there may be little or no benefit from ceasing funding to maintain the fixed protection.

Summary

It's only natural to want to limit tax charges of any kind, especially one designed to act as a cap on funding. But it's always important to look at all the options in the round. The alternatives will generally have their own tax consequences to be worked through before arriving at the most suitable outcome for the client.