What is the lifetime allowance?

The second key control under the new regime will be the lifetime allowance.

Although individuals can save as much as they like in registered schemes under the new regime, when they start to draw benefits (a 'benefit crystallisation event') the value of their fund will be tested against the lifetime allowance and any excess subject to the lifetime allowance charge.

There are eight different benefit crystallisation events. They cover, for example, the different ways an individual can begin to take a pension or the receipt of a lump sum in connection with a pension. As it will be possible to draw benefits in stages, for example, taking a pension on part of the pension fund and taking a pension in the remaining fund later, the calculations may be complex.

However on the first benefit crystallisation event the calculation will be relatively straightforward; a comparison will be made between the value being attributed to the event and the then lifetime allowance.

After much debate, the lifetime allowance has been set as follows: at £1.5 million for 2006/07 rising to £1.8 million for 2010/11. Thereafter the limit will be reviewed every five years.

The lifetime allowance charge on the balance of funds in excess of the lifetime allowance has been set at 25% with the balance of the fund being taken as a pension. There is an alternative of taking any excess as a lump sum but with a recovery charge of 55%.

Example of the lifetime allowance being breached

Sam has a pension fund valued at £2 million when the lifetime allowance is £1.5 million and he starts to draw benefits.

The fund up to £1.5 million can be used as a maximum tax-free lump sum of £375,000 (25%) and the balance used to buy a pension.

The excess of £500,000 is subject to a 25% lifetime allowance charge. The scheme will pay a £125,000 recovery charge to the Inland Revenue. The balance of £375,000 will be available to buy a pension.

Alternatively the recovery charge is 55% if Sam chooses to take the excess as a lump sum. The scheme will pay a £275,000 recovery charge to the Inland Revenue. Sam will receive the balance of £225,000 with no more tax to pay.

Although at first sight the 25% charge appears far better than the 55% charge, the charge at 25% may ultimately give rise to a maximum effective tax rate of 55% as well, since the 75% of the excess remaining in the fund will be used to buy a pension which may be taxed at 40%.