Dawn of new tax year brings changes to lifetime allowances rules for pensions
A NEW tax year welcomes a reset of allowances to be used throughout the year ahead, but 2024-25 sees the beginning of a new allowance rulebook for pension taxation.
After 17 years, the lifetime allowance is no longer the governing threshold for pension taxation and is consigned to history from this month. For those of you fortunate enough to be affected by this, the lifetime allowance was the total amount you can build up from pensions savings without incurring tax charges and was set at £1,073,100.
From the government’s perspective, this new policy is seen as a solution to a particular problem. In the words of Chancellor Jeremy Hunt, “these reforms will help ensure high-skilled individuals such as NHS clinicians are not disincentivised from remaining in the workforce”.
However, not one, but two, new allowances are being introduced.
Firstly, a lump sum allowance will govern lifetime lump sums. Secondly, a combined allowance will govern lifetime lump sums and death benefit lump sums.
Both allowances are limits on the lump sum benefits that can be paid tax-tree from a workplace or private pension. Once the allowances are used up, any further lump sums will be taxed at the recipient’s marginal rate of income tax.
What the abolished lifetime allowance and two new allowances have in common is the monetary limits involved. For most, lifetime tax-free lump sums will continue to be capped at £268,275 and the new combined lifetime and death benefits allowance has been set at the same level as the outgoing lifetime allowance of £1,073,100.
A small number of individuals may have higher allowances if they have registered for one of the various lifetime allowance protections that have been available throughout the years.
But as the new allowances are purely lump sum allowances there is a distinct difference compared to the lifetime allowance, in that a wider range of actions would have previously used up an individual’s available lifetime allowance, for example opting for a taxable pension.
What happens if you have already taken lump sum or pension benefits before this month that would have used up lifetime allowance? In short, previously-used lifetime allowance amounts will use up some of an individual’s new lump sum allowances. Care is required as it is the default calculation converting previously-used lifetime allowance amounts to the appropriate deductions under the new lump sum allowances – and this is where you could be caught out.
This is because pension schemes are required to deduct 25% of previously-used lifetime allowance amounts from the new lump sum allowances. The issue here is that the intent of the new allowances is to govern tax-free lump sums only, but under the broadbrush default calculation any previous pension benefits, taxable or tax-free, would count towards your tax-free allowance.
The good news is there is a remedy available. For individuals that have used less of their available lifetime allowance as tax-free lumps than under the default calculation, they can apply for a certificate that will calculate their remaining available new allowances based on actual previous tax-free lump sums received.
This is known as a transitional tax-free amount certificate and an individual should apply to the pension scheme from which they will receive the first lump sum that will count towards the new allowances.
Crucially, a condition for applying for a certificate is that it must be applied for before any event that will use up some of the new allowances.
There is no second bite at the cherry. For example, if you take a tax-free lump sum from your pension, but later discover you should have more allowance available than under the default calculation, your window for applying for a certificate has closed and you are stuck with the allowance available under the default calculation.
You must also be sure that when applying for a certificate you will be better off than relying on the default calculation. This is because the legislation does not provide an opportunity to revert to the default calculation. Once a certificate has been issued, the position is irrevocable.
The new regime also places more emphasis around flexibility when it comes to death benefit options, as inherited drawdown pensions do not use up the new combined lifetime and death benefit allowance whereas death benefit lump sums do.
The age 75 threshold will continue to dictate the tax treatment for death benefits. Where death occurs before age 75, death benefits will be tax free up to the new combined lifetime and death benefit allowance. Where death occurs after age 75, death benefits will be taxable.
This throws up the anomaly where death occurs before age 75 and the new combined lifetime and death benefit allowance is exhausted – any further lump sums would be taxable, whereas any withdrawals from an inherited drawdown pension would be tax-free. Being able to take advantage of such flexibility requires your pension scheme offering the option of an inherited drawdown pension and not all pension schemes do.
The best way of not getting caught out by these changes is to take some time now to properly understand how these changes impact your own situation and circumstances to determine what, if any, actions may be required. As always, given the potential complexity of the situation, it may be better to seek professional financial advice.
The good news is there is a remedy available