Tax-free lump sum and death benefits - case study

The case:

James retired from the police in 2015. He took a tax-free lump sum of £300,000 and started drawing a monthly pension. He then took on a private sector role and built up a defined contribution pension. At 55 he took 25% tax-free cash from this pot (around £30,000) and has not touched the remainder. He had then used up 100% of the lifetime allowance.

James has approached a new financial adviser. He has a third defined contribution plan and wants to know if he can take any more tax-free cash from it. He doesn’t have any lifetime allowance protection.

The prescription:

James’s new financial adviser explains from 6 April 2024 the pensions lifetime allowance has been replaced with two new key allowances. The lump sum allowance measures the tax-free lump sums a pension saver will take in their lifetime – from pension commencement lump sums and the tax-free part of ad-hoc lump sums (uncrystallised funds pensions lumps sums – or UFPLSs). The lump sum allowance is usually set at £268,275.

The lump sum and death benefit allowance measures the tax-free lump sums paid out in life (and measured against the lump sum allowance), plus any tax-free serious ill health lump sum and any lump sum paid out on death before age 75. The lump sum and death benefit allowance is usually set at £1,073,100.

For those who have taken some pension benefits before April 2024 and want to take others after April 2024, a transitional calculation works out what allowances that person has left.

As James used up his full lifetime allowance before April 2024, his new allowances are both zero. He is not allowed to take to any more tax-free lump sums.

James’s financial adviser wonders if applying for a transitional certificate could help James take more tax-free cash. But they quickly work out that James has already taken more than £268,275 as tax-free lump sums and so applying for a transitional certificate cannot help him with this.

James’s lump sum and death benefit allowance is also zero. His financial adviser explains this may not be a problem. This allowance is used to test lump sums paid out on death before age 75, with any excess being taxed. But on death after age 75 the allowance is irrelevant – instead all pension money paid from both income and as lump sums is taxed.

If he dies before age 75, there are two important exceptions where there is no test against the allowance.

First, if a lump sum is paid from funds that were taken before April 2024 – for example by being moved into drawdown – then there shouldn’t be a check against the allowance. (At the moment the legislation doesn’t reflect this intention, but HMRC will be issuing regulations to correct this.)

Second if money is paid out as an income, for example through a beneficiary’s drawdown plan, then that is not tested against the allowance.

James’s financial adviser recommends a course of action. First checking if his two defined contribution plans can be paid as drawdown to his beneficiaries. If not, James could consider transferring them to a contract that can. Nominations should also be up to date, making sure his loved ones have the most options.

Finally, the terms of the defined benefit scheme should be checked to establish what benefits it will pay out on death. Any dependant’s pensions will not be tested against the allowance.

As a final consideration, if James’s pension pots cannot be passed on as drawdown, and he doesn’t want to transfer, then he could apply for a transitional certificate. As he has taken £330,000 in tax-free lump sums, his lump sum and death benefit allowance would be reduced by this amount, to £743,100. Any lump sums paid out on his death before age 75 would be tested against this.