Scrapping the LTA tax charge – what this means in practice for your clients

When Chancellor Jeremy Hunt delivered his Spring Budget on 15 March 2023, one of the main headlines was the scrapping of the lifetime allowance charge in pension schemes. This came into effect on 6 April 2023 and is a precursor to a full dismantling of the lifetime allowance (LTA) in 2024/25.

With the draft legislation published and a few updates issued by HMRC on some of the mechanics, it’s worth looking at what this means in practice for clients with pensions in excess of the lifetime allowance in the following scenarios.

Recap of the 2022/23 rules

First, though, a quick reminder of how the LTA charge operated.

The standard LTA in 2022/23 was £1,073,100, although it’s been increased and decreased at various times since its introduction in 2006. If an individual took pension benefits in excess of the LTA, the rules gave them three options for dealing with the excess.

1. Receive the excess as a lump sum, subject to a 55% LTA charge.
2. Keep the excess in the pension scheme and use it to provide a form of income, subject to a 25% LTA charge.
3. A combination of 1 and 2.

The lower charge in option 2 is due to the fact that pension income would be subject to Income Tax. A higher rate taxpayer, for example, would likely see a broadly similar outcome either way in terms of overall tax paid.

At the age 75 BCE, only option 2 was available.

Scrapping the LTA charge

From 6 April 2023, however, no LTA charge can arise in any scenario. This is described in the explanatory notes to the legislation as a freestanding provision. Simply put, any time there is an LTA excess in the 2023/24 tax year, there will not be an LTA charge. That excess can now be dealt with in different ways, which is what we’ll cover in this article.

The Government intends this as a temporary measure while it considers how to fully weed out the LTA. We’re expecting a consultation later this year on the rules for 2024/25 and beyond. If, for any reason, the process doesn’t yield a new set of rules, the current rules remain in place.

For some clients this change is a real windfall, and I’ve seen examples from advisers where clients are saving hundreds of thousands of pounds.

There is a slight twist to the tale, however, given that certain lump sums are now taxed at the recipient’s marginal rate of Income Tax if the client has used all of their LTA. These are the lump sums in question.

• LTA excess lump sum
• Serious ill-health lump sum
• Defined benefits lump sum death benefit
• Uncrystallised funds lump sum death benefit

Taking benefits during the client’s lifetime

In terms of the practical impact, let’s look at a client who has uncrystallised funds but insufficient LTA to cover those funds.

The LTA still exists in 2023/24 and is still £1,073,100. Therefore, if your client is taking benefits this tax year, their pension provider will still ask for information on LTA usage under other schemes.

On the face of it, clients might wonder why their provider is doing this if the charge is being scrapped.

The key point to note here is that the limits for the tax-free pension commencement lump sum (PCLS) haven’t changed, and the PCLS is still limited to 25% of remaining available LTA (whether that’s the standard LTA or a protected LTA).

If a client exceeds the LTA, they won’t be able to take a PCLS from the excess. That’s the same as last year. The difference this year is that they won’t pay an LTA charge on the excess.

They will still have the option of taking the excess as an LTA excess lump sum if they want to. If they do, it will be subject to their marginal rate of Income Tax.

If they don’t take an LTA excess lump sum, it means more money for their income drawdown, lifetime annuity or scheme pension depending on the type of scheme. Unless the client has a specific need for the funds, it may be worth considering the pension option over the excess lump sum option as it means the Income Tax will be spread out over the years rather than being paid in one go like it would with a lump sum.

If you have clients who happened to take benefits in the lead up to the Spring Budget, and they incurred an LTA charge, they might ask if it can be reversed. Unfortunately, this might not be possible as there’s no obvious mechanism in the rules to do so (outside of 30-day cancellation rights), so it may come down to scheme administrator discretion.

Age 75 test

For the vast majority of clients, their 75th birthday is the final check-out point for LTA usage. There are three potential tests here depending on the type of scheme and whether the client has already taken benefits.

• BCE 5 – uncrystallised funds in a defined benefit scheme
• BCE 5A – growth on funds in income drawdown since initial designation
• BCE 5B – uncrystallised funds in a defined contribution scheme

A client might wonder why their provider is still doing the calculation given no LTA charge can arise. Again, it comes back to PCLS calculations.

The LTA used under BCE 5A (drawdown) is taken into consideration when working out how much LTA (and therefore PCLS) a client has left. The LTA used under BCE 5 and BCE 5B, however, is ignored for this purpose.

There is still a legislative requirement to perform all LTA tests and report the LTA usage to clients, but HMRC has intimated that providers can take a pragmatic view as to whether they do an LTA test where that test has no meaningful bearing on anything.

With a Consumer Duty hat on, some providers might opt not do BCE 5 and BCE 5B given they would be reporting LTA usage that has no relevance to the client.

Death benefits

If a client dies at any point from their 75th birthday, there is no LTA test, but the beneficiaries will pay Income Tax on those funds at their marginal rate. (This also applies if the client dies before age 75 but the funds aren’t designated for two years.)

If a client dies before the age of 75, it’s the other way round. Any uncrystallised funds paid out as death benefits are tested against the LTA of the deceased client. (Death benefits paid from drawdown funds are not tested against the LTA). However, they’re free from Income Tax. This applies whether the funds are taken as a lump sum or as a beneficiary’s pensions. It’s this aspect I want to focus on as this is where we have seen a change in the rules.

The LTA tests still take place, and it’s the responsibility of the client’s Legal Personal Representatives (LPRs) to determine whether the value of the death benefits exceeded the client’s remaining LTA. If it does, the beneficiaries will now pay Income Tax on the excess rather than an LTA charge.

HMRC initially indicated that from 6 April 2023 providers would be required to deduct the Income Tax via PAYE. This represented a change in process from before when the LPRs would notify HMRC, and HMRC would assess the beneficiaries for an LTA charge.

However, this would’ve been fraught with complications, and HMRC took on board feedback from the industry and reverted to the previous approach. The LPRs will send LTA info to HMRC. HMRC will then assess the beneficiaries for Income Tax. As far as we’re aware, this will still be apportioned on a ‘just and reasonable’ basis if being split between multiple beneficiaries.

Beneficiaries who are dependants, nominees or successors can choose to take the death benefits as a lump sum or a beneficiary’s pension. If the funds were uncrystallised, the lump sum would be subject to an LTA test. If there’s an LTA excess, they’ll pay Income Tax on those funds.

From a planning perspective, therefore, they may well be advised to take the pension option in LTA excess situations so they can manage the Income Tax liability over time, taking into account their personal allowance.

This was already a more appealing option for post-75 death benefits. That now applies to pre-75 death benefits too where there’s an LTA excess.

Some beneficiaries won’t fall into this basket. The most common example is family members, such as grandchildren, who weren’t specifically nominated, but who find themselves receiving the death benefits perhaps because the nominated beneficiaries have died or don’t need the money. There will also be some schemes whose rules don’t permit flexi-access drawdown. These individuals will only have the option of a lump sum.

Other BCEs

If you have a client transferring their UK pensions to an overseas pension, there will still be an LTA test on those funds given they’re leaving the UK tax environment. The test takes places regardless of the age of the client.

There can longer be an LTA charge on any LTA excess, but the provider will still conduct the test and report the usage to the client, as it would be relevant if the client still has uncrystallised funds in the UK from which they plan on taking a PCLS.

Technically speaking, a client can still take the excess as an LTA excess lump sum, which would now be subject to marginal rate, provided they’re age 55 or above, but most clients would presumably transfer the whole fund to the QROPS.

Serious ill-health lump sums are also affected by the change in rules. This is where a client has less than a year to live and takes their entire fund as a lump sum.

Previously the whole of the fund would have been paid free of Income Tax, although an LTA charge would’ve been paid on any excess over the LTA. Now, the part of the fund up to LTA is tax-free, and Income Tax is chargeable on the excess over the LTA.