You might have heard that the lump sum and death benefit allowance is changing - but do you know what this means for your money?
In this article, we’ll look into the intricacies of the new lump sum and death benefit allowance, giving you real peace of mind.
If you are navigating the financial and legal aspects of tax-free pension inheritance, or want to be prepared for the future, we've got you covered.
Table of Contents
- Who might be affected by the changes?
- What is the lump sum allowance (LSA)?
- What is the lump sum and death benefits allowance (LSDBA)?
- Abolition of the Lifetime Allowance Tax Charge
- Why is the Government bringing in the new measure?
- Impact on individuals, households, and families
- Get money, tax and debt help with Lawhive
Who might be affected by the changes?
It is likely that the proposed changes may affect:
Individuals who receive lump sum payments or death benefits from registered pensions schemes or relived non-UK pension schemes;
Those who have applied for or intend to apply for Lifetime Allowance (LTA) protections, lump sum protections, or LTA enhancement factors;
Individual members of relieved non-UK pension schemes and registered pension schemes who transfer their funds to a Qualifying Recognised Overseas Pension Scheme.
What is the lump sum allowance (LSA)?
After HRMC published a draft paper summarising proposed changes to how pensions are taxed, it became clear that the Lifetime Allowance Tax charge would be replaced by two new allowances: The Lump Sum Allowance (LSA) and the Lump Sum and Death Benefits Allowance (LSDBA).
The draft rules establish how pensions will be taxed for the tax year 2024/25 and going forwards.
The LSA will allow pension holders to allocate 25% of their pension fund tax free - this is known as a Pension Commencement Lump Sum (PCLS).
If you retire on or after 6 April 2023, you won't pay a lifetime allowance charge on the pension benefits paid to you. The maximum sum you will be able to take tax-free is £268, 275. Members with a protected right to a higher commencement lump sum on 5 April 2023 will continue to have access to these rights.
We’ll go into the abolition of the Lifetime Allowance Tax Charge in more detail later, but anyone with LTA protections can get a tax-free allowance based on their projected LSA. As an example, if you have Fixed Protection 2014, your LSA will be £375,000.
For many, the new rules will leave them considering whether to opt for a fixed tax-free sum or to gamble on taxable income.
This is a serious consideration as your future financial security and quality of life are at risk when you can no longer work.
It is always worth thinking about getting advice before making a decision that can affect your finances down the line.
What is the lump sum and death benefits allowance (LSDBA)?
The Lump Sum and Death Benefits Allowance is the second allowance that will be put in place to limit how much individuals can take as a tax-free sum from their pension.
This applies to during life and after death.
The new LDSBA will match the current LTA figure of £1,073,100. Like the LSA, this figure can't be increased.
If you have LTA protections under the old legislation, your LDSBA will be based on your LTA. To take the example of Fixed Protections 2014 again, your LSDBA in this case would be worth £1.5m.
If you have Enhanced Protection, your LDSBA will be set at the value of benefits that could have been taken when the new rules come in on April 5th, 2024.
If you have any Benefit Crystallisation Events (BCEs) that happen in the future or have already occurred, your LSDBA will be reduced based on these. BCEs are the payment of lump sums and lump sum death benefits.
These are more impactful than the BCEs that reduce the LSA.
Abolition of the Lifetime Allowance Tax Charge
Update: On March 18th, 2024, HMRC announced new regulations linked to the abolition of the lifetime allowance (LTA) as outlined in the Finance Act 2024.
These regulations, titled The Pensions (Abolition of Lifetime Allowance Charge etc) Regulations 2024, specifically address discrepancies and oversights in the pensions section of the Finance Act 2024.
The changes are set to implement an adjusted pension tax system starting from April 6th, where the LTA on pensions and lump sum benefits will be supplanted by two new allowances for most lump sum benefits.
At the Spring Budget 2023, the Government announced it would abolish LTA in April 2024. The Finance (No.2) Act 2023 started the ball rolling by removing the LTA charge and laying the groundwork to help make the removal of the charge easier to manage.
The Abolition of the Lifetime Allowance draft policy paper goes one step further to set out the changes needed to abolish the LTA and clarify the tax approach to pension savings. It can be explored in detail on Gov.uk.
The changes will impact a wide range of people including anyone who:
Receives lump sum payments or death benefits from a registered pension scheme or relieved non-UK pension schemes
Have applied or intended to apply for LTA protections
Have applied or intended to apply for lump sum protections
Have applied or intended to apply for LTA enhancement factors
Is an individual member of a relieved non-UK pension scheme
Has a registered pension scheme and transfer their funds to a Qualifying Recognised Overseas Pension Scheme (QROPS)
Scheme administrators of registered pension schemes
Relieved non-UK pension schemes who will need to modify their processes to accommodate changes to the taxation of lump sums
The policy paper clarifies the tax treatment for pensions:
Outlines how lump sums and death benefits will be calculated in absence of LTA
What people with LTA protections need to know
Lump sum projections and LTA enhancements
What BCEs are for
How tax transfers to QROPS are to be treated
Outlines transitional arrangements and reporting requirements
Why is the Government bringing in the new measure?
The philosophy behind the measure is to encourage people to return to work, particularly those over 50. This attempt is supported by the abolition of the LTA, which reduces the incentives to work less or retire completely, as pension tax-free limits are being reduced.
To understand the new measure fully, we need to explore the background of the now-disappearing LTA.
The LTA was first introduced in 2006 to limit tax favoured savings in registered pension schemes. This refers to the maximum amount someone can benefit from tax-relieving pension savings over their lifetime.
Under the rules at the time, individuals could contribute to their pension over the maximum limit, however, payments over the limit would be taxed. The limit in 2006 was £1.5 million, it was later raised to £1.8 million and further reduced over time to its current level of £1,073,100.
The Government were inspired to make these changes after the pandemic led to more people leaving work in the UK. They state the level of ‘economic inactivity’ is higher in the UK than in other countries.
The rationale for the changes is explained:
The Government believes that a strong labour market is critical to economic growth in the UK. Within this, encouraging labour market participation, and in turn growing the UK labour market, is a key mechanism to support the economy to produce more and increase gross domestic product (GDP).
Through the Finance (No. 2) Act 2023, legislation was introduced to prevent individuals from becoming liable to a new LTA charge from 6th April 2023 onwards. This was intended to incentivise those currently considering retirement to remain employed and encourage anyone who had already left the workforce to return.
Further changes are required to support the removal of the LTA charge, to deliver on the removal of the lifetime limit for total tax-relievable pension savings, and to ensure that pension tax continues to function effectively in the absence of the LTA charge and limit.
Impact on individuals, households, and families
Now we have covered the Government’s purpose for the new allowances, we’ll explore what this means for everyday people.
In the event of the death of a loved one under the new rules, the remaining LSDBA the pension holder has, minus any LSA used, can be drawn on to pay an authorised lump sum death benefit to the pension policy member. Tax-free benefits can be paid to a beneficiary of a will named under the LSDBA.
Any benefits above the LSDBA will be taxed at the recipient’s marginal tax rate. Furthermore, the pre-75 inherited drawdown will be taxable from April 2024. This means pension income will now always be taxable.
Additionally, inherited drawdowns and annuities from uncrystallised funds when the member died before they turned 75 will be taxable. Whereas lump sums within the LSA and LSDBA within the limits will not.
In terms of taxation of excess, when the lump sum is paid greater than the LSA or LSDBA, the excess will be taxed at the recipient’s marginal rate of income tax.
For lifetime payments, such PCLS and serious ill-health lump sums, the tax burden for the amount higher than the allowance is taxed against the member.
Any lump sum death benefits over the LSDBA will be assessed against the beneficiary. If there is more than one beneficiary, the allowance will be split between them and the tax they need to pay will be calculated.
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