Lifetime allowance - are you ready for the new rules?

As announced in last year's Spring Budget, the lifetime allowance (LTA) will be abolished on 5 April 2024. It will be replaced by a new set of rules that will instead limit tax-free lump sum payments both in lifetime and on death. There will be no limits on any funds used to provide a taxable pension income. 

Although no LTA charges have applied since 6 April 2023, for tax year 2023/24 the LTA framework has remained in place. This is an interim measure while HMRC work on a new set of rules to abolish the LTA entirely from 6 April 2024. HMRC have worked closely with the pensions industry to try and introduce a workable solution. Whilst there are a still a few technical issues to resolve, we now have a good idea of how the new rules are intended to work.

The aim is that there are no fundamental changes to the way pensions work. It’s just that new rules must be introduced to limit lump sum payments that were previously restricted by the LTA. The two new limits being introduced are:

The lump sum allowance

This limits the tax-free lump sums payable to the member in their lifetime, i.e. tax-free cash and the tax-free elements of uncrystallised pensions lump sums (UFPLS). The limit is set at £268,275 but can be higher for those with LTA protections.

The lump sum allowance (LSA) of £268,275 is a maximum. Tax-free cash entitlement is also still limited in the same way as it always has been, i.e. to 25% of the uncrystallised funds or one third of the amount designated to provide income.

Example

An individual with an uncrystallised pension fund worth £800,000 would be limited to tax-free cash of £200,000. An individual with a fund worth £1.2m and no protection would be limited to the maximum LSA of £268,275.

The tax-free cash entitlement is limited to the lower of 25% of the value of the funds or the LSA.

Any lump sum paid in excess of the limits will be subject to income tax at the member’s marginal rates.  

Anything paid as pension income will not be tested and will be subject to income tax in the normal way.

The lump sum and death benefits allowance

This limits the amount of tax-free lump sum that can be paid both in lifetime and on death. The lump sum and death benefit allowance (LSDBA) is set at £1,073,100 but can be higher for those with LTA protections.

Where the member has taken any LSA during their lifetime, this will reduce the available LSDBA paid on death.

If death occurs before age 75, anything paid as a lump sum above the available LSDBA will be taxed at the beneficiary’s marginal rates of income tax.  

Example

A member has taken £100,000 of tax-free cash and moved £300,000 into drawdown in June 2024. They have a further £800,000 of uncrystallised funds. If they died in August 2024 and aged under 75, the maximum tax-free lump sum payment that could be paid would be £973,100. If the excess of £126,900 is paid as a lump sum, it is subject to the beneficiary’s marginal rates of income. If it is paid as income, i.e. drawdown or as an annuity, no tax charge will apply.  

Note, as shown in this example, lump sum payments on death from drawdown funds  are included in the LSDBA whereas, under the LTA rules, they were not tested on death (please see the section below on pre-6 April 2024 drawdown).

Where individuals have benefits in excess of the LSDBA, they should ensure that the option of paying death benefits as beneficiary’s drawdown is available wherever possible. This will mean that, on death under the age of 75, all benefits could continue to be paid free of tax regardless of the value. 

Those with LTA protections will have both higher tax-free cash limits and higher lump sum and lump sum death benefit limits (please see the later section).

The tax-free element of any UFPLS will reduce both the LSA and the LSDBA. Payments made under the trivial commutation, small pots or winding up lump sum rules will not count towards the lump sum limits.

Where death occurs aged 75 or over, all benefits become taxable at the beneficiary’s marginal rates of income tax in the same way as currently.

Age 75 tests

The age 75 tests on funds in drawdown and any uncrystallised funds will no longer apply. This is because no lump sums are paid out of the scheme and so there is nothing to test.

Any tax-free cash taken age 75 or over will be subject to the LSA in the normal way along with the tax-free element of any UFPLS payments.

Benefits tested before 6 April 2024

From 6 April 2024, only lump sum payments are tested against the limits and for those taking benefits for the first time the rules are relatively straightforward. However, many people will have already taken benefits prior to 6 April 2024 and these need to be taken into account.

To achieve this, the member’s previously used LTA percentage will be converted into a reduction in both the LSA and the LSDBA.

Where the member has previously used 100% or more of their LTA, under the standard calculation method there will be no entitlement to either LSA or LSDBA. Where the LTA used is less than 100%, both the LSA and LSDBA will be reduced by 25% of the total LTA previously used.

Example 1

An individual has previously used 40% of the LTA. In monetary terms this is £429,240. Both their LSA and LSDBA will be reduced 25% of this value, i.e. £107,310.

Therefore, their LSA will reduce to £160,965 and their LSDBA will reduce to £965,790.

As well as the standard method of valuation, members can also apply for a transitional tax-free cash certificate.

This option will primarily be for those who have taken their defined benefit pensions without the maximum tax-free cash entitlement, because of either restrictions in the scheme rules or unattractive commutation factors.

Example 2

A member took their defined benefit pension of £25,000 a year in June 2017, when the LTA was £1m. They took no tax-free cash. This will have used up 50% of the LTA, i.e. £25,000 x 20/£1m.

Under the current rules, they would now be restricted to tax-free cash of 25% of 50% of the LTA. The change will allow them to take up to the full £268,275, providing they still have uncrystallised funds worth £1,073,100 or more.

Pre-6 April 2024 drawdown

Any funds placed into drawdown pre-6 April 2024 will not be tested against the LSDBA on death. The logic being that they will have already been previously tested under the LTA and so should not be tested again.

This contrasts to the position for payments designated into drawdown from 6 April 2024. These payments will not be tested when they are designated to drawdown as they are being used to provide income rather than a lump sum. They therefore will be tested against the LSDBA if paid out as a lump sum on death.  

Protected LTAs

Those with protected LTAs will maintain their higher tax-free cash entitlement as they will have a higher LSA. The higher protected LTA will also translate into a higher LSDBA.  

Example 1

An individual with Fixed Protection 2014 will have a LSA of £375,000 and an LSDBA of £1.5 million.

An individual with Individual Protection 2016 and a protected value of £1.2m will have a LSA or £300,000 and a LSDBA of £1.2m

Where those with LTA protection have already crystallised some of their benefits prior to 6 April 2024, their LSA and LSDBA will be reduced in the same way as those with the standard allowances as described above.

Example 2

An individual with Fixed Protection 2016 used up 40% of their LTA. Their LSA and LSDBA are both reduced by 25% of this. Their LSA is reduced by £125,000 to £187,500. Their LSDBA is reduced from £1.25m to £1,125,000. 

If you would like to discuss the upcoming changes, please contact your usual TPO adviser.

This information is correct as at 19/02/24.

The information in this article is based on current laws and regulations which are subject to change as at future legislations.

This article is intended for general information only, it does not constitute individual advice and should not be used to inform financial decisions.

The Financial Conduct Authority (FCA) does not regulate tax advice or estate planning.