Why you still need to worry about the pension lifetime allowance

When the Chancellor announced in his March 2023 Budget that lifetime limits on pension tax relief were to be abolished, many pension savers were delighted. No longer did they need to worry about the risk of going over the lifetime allowance ( LTA) and incurring a tax charge on any pensions taken above that level.

However, as with so many Budget announcements, there was a catch in the small print. Although the lifetime allowance was going, a new limit was created to stop the amount of tax-free cash that you can take increasing.

Given that the LTA was previously set at £1,073,100, and that you can generally take 25pc of your pension as taxfree cash, the new lifetime limit – known as the lump sum allowance or LSA – is 25pc of the old cap or £268,275. It will still be possible to take lump sums above this amount, but anything above it will be treated as taxable income.

For those who have yet to take their first pension, the system will be relatively simple. From now on, when you take a pension and take some tax-free cash, your pension scheme or provider will set out in writing how much of your LSA you have used. If you then take a second pot you are required to tell the next pension provider how much of the lump sum allowance you have used up. If the second tax-free lump sum takes you over the limit, the second provider will collect the tax on the excess.

One surprising feature of this system is that it is the taxpayer who is expected to store this information – not HMRC.

Things are more complicated with regard to pensions you have already taken. With the new system coming in, HMRC did not want to ignore the taxfree lump sums which people had already taken, and plans to score those against the newly created lump sum cap. But with no historical records this created a problem.

The way HMRC has “solved” it is to estimate how much you have taken in tax-free lump sums based on the information you should have kept on the total amount of lifetime allowance you had used before it was abolished.

To give a simple example of how this could work, suppose – to keep the maths simple – that the lifetime allowance was precisely £1m, and that you had used up 50pc of your allowance to date based on one or more past pension withdrawals. They would look at the £500,000 used up (50pc of the LTA) and assume that 25pc of this was in the form of tax-free cash. On this basis, they would say you have used £125,000 of your new lifetime limit for tax-free cash.

However, for some people this assumption will be far too much.

For example, in many public service defined-benefit pension schemes you have to give up a lot of pension income in exchange for a tax-free lump sum.

If you are in this situation there is a solution – you can apply for something called a “transitional tax-free amount certificate”. It is a piece of paper which shows the actual amount of tax-free cash which you took rather than the amount HMRC would otherwise assume. It is well worth investigating this possibility if you took less tax-free cash from a previous pension than the figure HMRC will assume and have further pensions still to take.

As ever, the golden rule is to keep all of your paperwork. The lifetime allowance may have gone away, but the need to keep records of all of your pensions, including ones you’ve taken in the past, has not.