Pension Clinic: it is perfectly legal to exceed both your annual and lifetime tax-free pension saving limits, and it can make financial sense to do so.
Regular readers will be aware that HMRC imposes both annual and lifetime limits on the amount of money you can save into a pension while benefiting from tax relief on contributions. What is much less widely known is that it is perfectly legal to exceed those limits, and that in some circumstances it can make good financial sense to do so.
To explain why it might be beneficial to go on saving beyond your annual limit, or to build up a pot beyond your lifetime limit, it is worth outlining how the two limits work.
Know your limits
Starting with the annual allowance, most people can currently contribute £40,000 into a pension each year and receive tax relief on their contributions. There are two main groups of people who may have a lower annual allowance: higher earners, whose allowance can be ‘tapered’ to as low as £10,000, and those who have already started to draw taxable cash from their pension pots, who may be limited to £4,000 a year of tax-free contributions. For the purposes of this article, however, we will assume your annual allowance is £40,000.
Although your annual allowance is £40,000, there is nothing to stop you putting more than this into your pension. You simply declare what you are doing on your tax return and pay the resultant tax bill. Suppose, for example, that you put £45,000 into your pension in a given financial year. In general, you will have benefited from tax relief on the full £45,000. But because you are only entitled to tax relief on the first £40,000, HMRC will need to claw back the tax relief on £5,000.
The gov.uk website says simply: “The amount you went above the annual allowance is added to your taxable income. You pay income tax on taxable income at the tax rate that applies to you.” This means that if you pay tax at 20%, you will have a tax bill of 20% of £5,000, or £1,000; if you pay at 40%, you will have a tax charge of £2,000; and so on.
Turning to the lifetime allowance, if you exceed your lifetime allowance (£1.03 million in 2018/19), a similar process applies, but the tax is worked out in a different way. If you take the money out in the form of regular pension payments, you pay a tax charge of 25% (over and above any other income tax due), and if you take it out as a lump sum, you pay a tax charge of 55%.
So why on earth would anyone willingly incur such a tax bill? The short answer is that pension contribution rules can be so generous that, even allowing for the tax clawback, you are still better off contributing than not.
Let me give a couple of examples to make the point. The first is a modern ‘pot of money’ or defined contribution pension arrangement. Suppose you have a generous employer who puts in £2 for every £1 you pay into your pension. Normally, your £1 only costs you 80p or 60p, because you get tax relief on the contribution. But even if you breach the £40,000 annual limit and have to pay back 20% of £3 in tax, you still end up with £2.40 net for your 80p contribution. Even allowing for the tax charge, you would be worse off if you decided not to contribute beyond your annual allowance limit.
A second example relates to members of salary-related pension schemes. The way accruals in salary-related pensions are tested against annual and lifetime allowances is a bit more complex, but the basic principle still applies. When you contribute to a salary-related pension your employer also contributes, often much more than you do. If you opt out, you lose that contribution. Even in cases where you might exceed annual or lifetime limits, opting out could cost you far more than paying a tax charge.
These are complex calculations. If you are someone who could put £40,000 or more into a pension or has a lifetime pot worth more than £1 million, you should probably invest in some tailored financial advice to help you decide on the most beneficial course of action for you. But I hope it is now clear that reaching annual or lifetime limits for tax relief need not automatically put a limit on your pension saving.
Steve Webb is director of policy at Royal London.