Interactive Investor

Getting to grips with new pension tax-free lump sum allowances

The lifetime allowance has been replaced with three new pension limits, but knowing how they affect you is not necessarily straightforward, writes Craig Rickman.

16th May 2024 16:16

by Craig Rickman from interactive investor

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On 6 April 2024 the pensions lifetime allowance (LTA) was officially done away with. Good riddance is the majority view among savers.

The LTA placed a cap on what your total pension savings could be worth without being hit with heavy tax penalties.

In some cases, this could be an eye-watering 55%, which explains the delight when Chancellor Jeremy Hunt unexpectedly abolished the policy at his 2023 Spring Budget.

But further inspection of Hunt’s decision in the Budget’s red pages unearthed a catch. And the implications of this have become increasingly apparent.

While the LTA charge was scrapped from 6 April 2023, and the allowance has now been binned entirely, the amount that you can draw tax free has been capped at £268,275 – 25% of the previous LTA limit.

This may seem a healthy sum, and indeed it is for most savers. You will need to amass more than £1 million in pension savings to reach the maximum tax-free cash entitlement.

However, this means that rather than simplifying the pensions tax landscape, something that’s long overdue, for some people it’s made things more complicated.

The LTA may be no more, but its ghost remains and forms the basis of the three new allowances that came into force from 6 April. These cap the amount of lump sums and death benefits you can draw free from income tax, plus there are limits for overseas pension transfers.

As some of the detail here is knotty, the aim of this article is to provide an overview rather than an in-depth guide, to help you to identify whether you need to take action to make the most of your tax-free entitlement. To deepen the complexity, it’s possible that the LTA could be reinstated at some point.

New tax-free cash regime

As many savers will already be aware, the maximum you can draw from your pension tax free is typically 25% of your total pension savings. But as noted above, there is a new allowance which places a cap on this figure.

Under the individual lump sum allowance (LSA), the maximum you can draw tax free is £268,275, though it may be higher if you secured one of the various forms of LTA protections.

So, what counts towards your LSA? Well, there are three things:

  • any pension commencement lump sum (tax-free cash)
  • the tax-free element of uncrystallised funds pension lump sums (UFPLS) - where 25% of what you take is tax free while the rest is taxable, and
  • any tax-free element of a stand-alone lump sum.

Each time you take a tax-free lump sum from your pension, your LSA will reduce. Once you’ve used it up, any future withdrawals will be taxable.

The calculation is fairly simple if you’re yet to draw any pension benefits. But if you’ve taken some before April and plan to draw more tax-free cash in the future, things might be a bit complicated.

Could you get an enhanced tax-free lump sum?

The short answer here is yes – it’s possible. As noted above, if you registered for one of the various LTA protections you could get a more generous tax-free entitlement. For those who are eligible to apply for fixed protection 2016 or individual protection 2016,  there is still time to apply, as the deadline date for applications is 5 April 2025.

If you accessed some of your pensions before 6 April and took less than 25% tax-free cash, you can apply for what’s called a transitional tax-free amount certificate (TTAFC).

This can help secure you a greater tax-free lump sum.

This might be handy if you took a defined benefit (DB) scheme where the maximum tax-free entitlement is often lower than 25%. Alternatively, you may have opted for a lower tax-free cash percentage when going into drawdown to leave some spare for a later date.

To obtain a TTAFC you will need to evidence how much tax-free cash you’ve used in the past and furnish this to your pension scheme.

An important thing to flag is that you must have a TTAFC in place before a relevant benefit crystallisation event occurs post 6 April 2024 (for example, you make an UFPLS withdrawal), otherwise the standard calculation will apply, and you could lose out.

Changes to lump sum benefits on death and serious ill health

From 6 April we saw also the introduction of the lump sum and death benefits allowance (LSDBA).

This is the maximum you or your beneficiaries can take from all your pension schemes as a tax-free lump sum before age 75, paid on either death or serious illness.

The LSBDA has been capped at £1,073,100, but once again your allowance might be higher if you secured a previous LTA protection. Each time you take a tax-free lump sum from your pension, or a tax-free lump sum is paid on your death, you’ll use up some of your LSDBA. Anything above is normally subject to income tax.

Importantly, the LSDBA does not apply to death benefits before age 75 taken tax-free as regular income - only if drawn as a lump sum.

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What’s the deal if you transfer pensions to another country?

Now that many people decide to move abroad, either before retirement or afterwards, it can be important to be aware of the rules that apply when moving pensions overseas.

Since 6 April, there is now an overseas transfer allowance, also set at £1,073,100, the same level as the LSDBA.

In any event, when transferring pension benefits to a different country, it’s essential to not only seek expert advice but to make sure the adviser understands both UK tax rules and those of the country you’re emigrating to.

Is there anything that’s not tested against these allowances?

Well, the answer is yes, but only a few things. Any small pots that you access (anything less than £10,000) are exempt from both the LSA and LSDBA. And anything you leave to charity is not tested against the LSDBA.

Murkiness remains so some savers must tread carefully

In an interesting and honest move, HMRC recently conceded that the rules here are yet to be fully formed. This is a bit concerning, especially for savers who plan or need to access their pension savings soon.

In a somewhat alarming statement, just two days before the 2024-25 tax year started, the UK’s tax and customs authority said: “Schemes should ensure that members are aware of the need for further legislative changes. As a result, members may need to wait until the regulations are in place before taking or transferring certain benefits. This is to ensure that their available allowances and tax position do not need to be revisited later in the year.”

Will the LTA make a comeback?

There are other potential complications down the track, too. The Labour Party has pledged to bring back the policy if it wins power and has a commanding lead at the polls with a general election looming later this year.

There are clearly no guarantees – voters could experience a change of heart once decision time arrives, and Labour could prioritise other things over lifetime pension limits. Still, it’s something pension savers are wary of. You may wonder whether you should act now before the rules potentially change again.

In a recent conversation with Citywire’s New Model Adviser, former pensions minister Steve Webb claimed that while Labour will seek to restore the LTA should it gain power, this is unlikely to happen before April 2026 and the allowance will be higher than the previous limit of £1,073,100.

This development, and other recent changes, may prove unsettling to savers who are in desperate need of simplicity and clarity when it comes to drawing pension benefits. Making the best use of any tax-free element is crucial to making sure your pension savings last as long as you do.

Critics may argue that only a proportion of people are affected by these new allowances. And even if Labour wins the upcoming election and revives the LTA, only those with the biggest pots will breach its limit.

The problem here is that repeated tinkering within the pension landscape, particularly when it makes things more complex rather than simpler, may lead to less engagement rather than more.

In the meantime, if you’re struggling to get your head around the new allowances and are concerned that they might affect you, rest assured you’re not alone. The best course of action in this instance is to seek professional advice from a financial planner, one that specialises in complex pension areas.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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