Pension pot-roast

It's not surprising that many people seriously underestimate how much money they need to salt away for a comfortable retirement. Pensions are hardly the dinner party subject of choice. But it would be foolish to brush it under the carpet altogether.

A pension pot of £500,000 sounds like a decent sum, but that may only buy someone an annual income of about £28,000. And for a pension pot of £500,000, you need to put in more than £225 each month, assuming you start saving at the age of 25. Leave it until 35 and that monthly figure jumps to more than £450. At 45, it becomes more than £900 a month.

Of course, in my line of work I have many clients who are not saving enough, but they have other gremlins to face.

New government rules mean that the amount someone can accumulate in pensions over their lifetime (known as the lifetime allowance or LTA) and how much they can save each year (annual allowance) will be cut from next April.

The LTA has been steadily coming down. It was cut from £1.8m to £1.5m in 2012, and from 6 April 2014, the limit will take another cut to £1.25m. For many people, particularly professionals, a £1m-plus pension pot sounds a sizeable sum, but many workers could unwittingly be caught out by the limit. When the government made the first change in 2012, the NHS alerted its consultants and surgeons on what it meant for them.

Those with a pension pot in the region of £750,000 and those who are just five years from retirement have the most to think about. They should review their retirement plans now to assess whether they are in danger of exceeding the new reduced allowance. This includes people in final salary schemes, which also come under the lifetime allowance rule.

Any person with a pension fund that exceeds the limit when they take pension benefits will be hit with a 25 per cent tax charge if the excess is taken as a pension, and 55 per cent if the excess is taken as a cash lump sum.

People's choice

All is not lost, though. People have a choice and they can opt to keep the higher £1.5m lifetime pension allowance by opting for "fixed protection". But while they can keep the higher £1.5m lifetime allowance there are conditions attached.

For example, for workers in company pension schemes, it means taking the potentially drastic step of opting out of the scheme and potentially forgoing an employer's contribution if they want to opt for fixed protection. This is because if someone pays into a pension plan after opting for fixed protection, that protection is lost.

There is another consideration, which could affect the amount people can take as tax-free cash. If someone opts to protect the existing £1.5m limit, they will be eligible to take a 25 per cent tax-free lump sum of up to £375,000 when they retire. Without fixed protection, the maximum tax-free lump sum will be based on the lower lifetime allowance, 25 per cent of £1.25m or £312,500.

Double whammy

And there's more to consider. If someone who opts not to use fixed protection and ends up with a pension worth between the current limit of £1.5m and the soon-to-be reduced limit of £1.25m, they'll be hit by a double whammy: not only will they pay tax on the amount in excess of £1.25m, they will only qualify for the lower tax-free cash of £312,500.

As you can see, the decision on whether to apply for fixed protection is complex, so it will pay to get specialist advice. This is also important because the rules on protection change in April 2014 and, depending on someone's circumstances, to leave it until then could be leaving it too late.

The second change that is set to affect professionals is the amount they can contribute into a pension each year and receive tax relief (the annual allowance). This will be cut to £40,000 from £50,000 in April 2014. Exceed your annual allowance and you're liable to a tax charge.

Again, professionals making sizeable contributions may want to review their options - not only to maximise their contributions for this tax year, but to take advantage of HMRC rules that allow people to carry forward any unused limits from previous years (although there are restrictions on how far back you can go).

Rebecca Hughes is market leader, professionals at Coutts

Coutts writes a regular blog for Private Client Adviser