Your Pension and the end of the Lifetime Allowance

In the spring Budget it was announced the ‘lifetime allowance’ was being abolished. 

The date was set, 6^th April 2024, and before this, the lifetime allowance tax charge would be set to 0%. 

The measure was aimed to support the governments’ objective of boosting the UK labour market. To discourage early retirement, and encourage work, especially for the over 50’s. Since the pandemic, the UK’s economic activity has been below that of other advanced economies and the government believed a strong labour market would stimulate productivity, spending and growth.  

In late July HMRC published a policy paper on the abolition of the lifetime allowance (LTA) and the proposed new rules from 6^th April 2024. 

https://www.gov.uk/government/publications/abolishing-the-pensions-lifetime-allowance/abolition-of-the-lifetime-allowance

We now have a clear idea on the impact these rule changes will have on pension planning and importantly, the changes being proposed to the way pension lump sums can be paid free of tax

Key highlights 

1. There are two new allowances you will need to understand – the Lump Sum Allowance (LSA) which limits your pensions tax free cash, and the Lump Sum and Death Benefit Allowance (LS&DBA) which limits tax free death benefits.  
   
2. Not published in the draft legislation the policy paper suggests a change to the taxation of pension income death benefits with beneficiaries’ drawdown and annuities from pre-75 deaths becoming taxable after April. Currently they are tax free. We do not believe those with existing tax-free inherited pensions will, from 2024 become taxable, but we await clarification. 
   
3. Death benefits post- 75 are unchanged. Pension withdrawals are taxed to income in the hands of the beneficiaries.
   

What’s changing from April 2024?

The lifetime allowance was retained for the current tax year, but the tax charge for exceeding it is set to zero. From next April, it will cease to exist completely. Hurray! 

Whilst the government has asked HMRC to completely remove the lifetime allowance, they do want to maintain a cap and limit what can be taken as a tax-free lump sum. Everything else is to be taxed as income.

This has led to the introduction of two new tax-free allowances for pension lump sums.

Lump sum allowance (LSA)

It will still be possible to take 25% of your pension tax free as a pension commencement lump sum (PCLS). However, you must have sufficient lump sum allowance for it to be tax free. 

The lump sum allowance has been set at £268,275 for those without existing pension protection.

In addition to pension commencement lump sums, the tax-free elements of the following lump sums will also count towards the allowance:

• Uncrystallised pension lump sums (UFPLS)
• Trivial commutation lump sums
• Winding-up lump sums

At the time of writing, it seems that any tax-free element from small pot pensions (usually valued at less than £10,000) will not count towards the lump sum allowance.

Lump sum and death benefit allowance (LS&DBA)

A second allowance will be used to limit how much can be paid as a tax-free lump sum, both during lifetime and on death. This allowance will match the current lifetime allowance at £1,073,100. The following lump sums will be tested against the allowance:

• Defined benefit or final salary pension lump sum death benefits
• Pension and annuity protection lump sum death benefits
• Uncrystallised funds lump sum death benefits
• Drawdown pension fund lump sum death benefits 
• Trivial commutation lump sum death benefits
• Serious ill-health lump sums
• Pension commencement lump sums* (your 25% tax-free cash)
• The tax-free elements of:
  • Uncrystallised pension lump sums (UFPLS)*
  • Trivial commutation lump sums*
  • Winding-up lump sums*

* You will note that these are also tested against the lump sum allowance!

It is important to note that this is a cumulative allowance. The amount available for tax free lump sum death benefits will be reduced by any tax-free cash amounts the member has taken during their lifetime.

How could this work in reality? An example.

In the summer of 2024 Abigail, age 63, has a pension valued at £1,000,000. She decides to take her full tax-free pension commencement lump sum, which is 25% of her pension – £250,000.

This is perfectly allowable as it sits within the new lump sum allowance of £268,275, and she has taken no lump sums before.    

By taking her lump sum, Abigail understands she has also used £250,000 of her lump sum death benefit allowance. 

If she were to die before age 75, the maximum lump sum death benefit which could be paid tax free is £823,100 (£1,073,100 less the £250,000 taken.) Should Abigail’s remaining pension fund be worth more than £823,100 on her death, the excess sum would be taxed as income at her beneficiaries’ marginal tax rate.   

Testing the allowances 

With the lifetime allowance gone, only lump sum testing remains. Previous lifetime allowance usage is no longer relevant. 

And it is only the monetary amount of previous lump sums that are needed to test how much of the new allowances is still available. 

The draft legislation does not provide for any revaluation on previously taken lump sums, though there are still transitional rules to be published which could cover this.

It is worth noting that the notion of crystallised and uncrystallised funds no longer has any bearing on what can be paid as a tax-free lump sum on death before age 75. 

After April it will not matter whether lump sum death benefits paid pre-75 come from crystallised or uncrystallised funds; both will count towards the lump sum and death benefit allowance.

Pension protection

The role of the various protection regimes you may have registered for now becomes solely about increasing the amount of tax-free lump sums available by increasing the amount of lump sum allowance and the lump sum and death benefit allowance.

As this is a slightly complex area, so I would suggest you seek advice on your own situation, but in summary:

• Those with fixed or individual protection will have their death benefit allowance set to their protected lifetime allowance with their lump sum allowance 25% of that amount.

• Those with primary protection will have their lump sum and death benefit allowance set to £1.8million increased by their primary protection factor. 

• Those with enhanced protection will have their allowances set to the value of their uncrystallised pensions as of 5 April 2024. Without protected tax-free cash their lump sum allowance is £375,000, less any sums already taken.

• Individuals with registered tax-free cash protection under enhanced protection will have their lump sum allowance limited to what could have been paid out on 5 April 2023.

Taxation of excess – who pays?

When a lump sum is paid which is greater than the lump sum allowance or death benefit allowance the excess is taxable at the recipient’s marginal rate of income tax. 

For lifetime payments such as pension commencement lump sums or serious ill-health lumps sums, the amount over the allowance is taxed upon the member.

Lump sum death benefits exceeding the allowances will be assessed against the beneficiaries. Where there is more than one beneficiary, the available allowance will be apportioned between them to determine how much tax each will have to pay.

If the excess lump sum is payable to a non-qualifying entity, such as a trust, it will be subject to basic rate tax. However, if it is paid out more than two years after death or after age 75, the rate of tax due will increase to 45%.

The small ‘sting in the tail’.

Under current rules, where someone dies before the age of 75, and their pension is within the lifetime allowance, pension income is tax free when the beneficiary decides to start withdrawing money.

The policy paper highlights a significant change to the taxation of this pension income. From the tax year commencing April 2024, pension income will always be taxable.

Inherited pensions and annuities purchased from uncrystallised funds, where the member dies pre-75 will become taxable. This contrasts with lump sums paid from the same funds, which will be tax free within the available lump sum and death benefit allowance!  

This basically puts things back to the position before 2015 and pension freedom. It could soon be more tax efficient to take the pension as a lump sum than an income. 

What’s next? 

There is no formal consultation on these changes, HMRC will continue to work with the lifetime allowance working group and legislation will be passed. 

It’s  possible that further changes may be made before any of the draft legislation is enacted, but we now have an insight on the future pension framework for 2024-25 and beyond.

Pensions form the backbone of most financial plans. Their ability to provide you with tax efficient savings, tax free growth, and then a flexible income during your lifetime is incredibly valuable. 

The removal of the lifetime allowance reinforces how valuable pensions are and should encourage more savings. 

However, retirement plans may need to be adjusted. There is now a clear distinction between pension lump sums, being tax free, (within the allowances,) and pension income, being taxable. 

In our experience, retirement income strategies are developed to minimise taxation – both income tax during lifetime and inheritance tax on death. 

Currently, beneficiaries of death benefits have access to tax free lump sums and tax-free income if the member dies before age 75. This tax advantage looks to be going.

For those inheriting a pension and wanting an income, not a lump sum, the tax collector is waiting for you!High quality advice has never been more important.