The Prime Minister said she was working to get a full deal negotiated before Brexit day, but acknowledged it can not be signed until after the UK's withdrawal, expected on March 29 2019.
The EU has said it wants to have a free trade deal with Britain ready to go at the start of 2021, as soon as the transition ends.
Legislation meant to smooth Britain's exit from the European Union moves a step closer to becoming law on Wednesday, as ministers begin working out what they want from Brexit.
But it should be over by the end of December 2020.
The cut-off date for the transition phase is contained in the EU's guidelines for the next phase of Brexit negotiations.
Talks on a transition period are due to start in January after a green light from European Union ministers, with Britain hoping for an agreement on the main principles by March.
Chief EU negotiator Michel Barnier clarifies that the transition period will not be an "a la carte" for Britain to choose from. Rulings of the European Court of Justice will continue to apply, the EU said.
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Chancellor Philip Hammond said: "I am confident that we will agree a deep and special partnership for the future with the EU27 and that we will soon finalise the terms of an implementation period that will provide continuity as we move to that new partnership".
In a tough speech, Mr Barnier said the transition must be for a "short and specific" period.
"The sooner there is a clear position as to what the outcome [of European Union negotiations] will be, the better", Ms Lagarde said.
He appeared to indicate that Spain would have a veto on any transitional arrangements covering Gibraltar, saying decisions on the issue would be "made for the 27, unanimously, by consensus".
The Bank of England, seeking to protect the City of London's status as a global financial hub, said it would spare European banks costly capital rules after Brexit but warned of "consequences" if negotiations with Brussels turned sour.
Mr Barnier warned that "logically speaking", when the United Kingdom leaves the European institutions in March 2019, it will no longer be covered by around 750 global agreements - including dozens of free trade deals - negotiated by the EU while it was a member.
On the broader question of what kind of trade deal will be possible, Mr Barnier restated his view that the PM's Brexit plan - which includes leaving the bloc's single market and customs union - means Brussels can only offer an agreement similar to ones negotiated with Canada, South Korea and Japan.