Tax doctor: How LTA protection affects lump sum from a £3m pension

The case

Jason is aged 73.

In 2006 he applied for enhanced protection when his pension plan was worth £1.41 million. At the same time, he applied for tax-free cash lump sum protection. The percentage recorded on the protection certificate was 28%.

He now has a SIPP which was worth £2.8 million on 5 April 2023.

He has heard that because of the Spring Budget changes there will be no further lifetime allowance charges from 6 April 2023, and that the intention is to abolish the lifetime allowance altogether. He is also aware that he can now start contributing again to his pension without losing his protection.

He wants to pay in another £100,000 and wants to know how much tax-free cash he could take if he crystallised the fund in December.

The prescription

The Finance Bill is currently progressing through Parliament. It includes draft clauses that prevent the lifetime allowance charge from arising, as well as allowing those with enhanced or fixed lifetime allowance protection to contribute without losing the protection of a higher tax-free cash amount.

However, the Bill also restricts the amount of tax-free cash those with enhanced protection could take to the lower of either the applicable percentage (written on their protection certificate) of the fund they are crystallising or the applicable percentage of their fund on 5 April 2023.

So, if Jason does pay £100,000, and his pension fund increases to, say, £3 million in December, if he crystallised all his fund he could take tax-free cash equal to the lower of:

• £840,000 (28% of £3 million – his current fund value); or
• £784,000 (28% of £2.8 million – the fund value on 5 April 2023).

Because the tax-free cash amount for these individuals is defined as a percentage, and not a fixed amount (like other types of protections) there was a danger people could pay more contributions into a pension after 6 April 2023 and benefit from a higher tax-free cash amount. HMRC wanted to stop this.

However, currently the draft legislation does not appear to be watertight.

If Jason was to split his crystallisation in two and take £1.5 million each time, then he could take £420,000 tax-free cash at each crystallisation (28% of £1.5 million is lower than £784,000). This gives him a total of £840,000. This is because previous crystallisations have not been included in the calculation of the maximum tax-free cash.

This appears to sidestep the intention of the legislation. But it may not be as clear cut as that.

The Bill has not yet been passed, and therefore the exact wording of final legislation may still be changed. HMRC could easily expand the definition of the maximum tax-free cash for these people with enhanced protection to include (revalued) previous tax-free cash amounts taken. This would make sense and would fit in with the future intention of limiting the overall amount of tax-free cash someone can take. Even if it doesn’t expand the calculation this time around, HMRC could do so in next year’s Finance Bill.

If the legislation remains the same, some pension schemes may not facilitate it, and advisers and their clients may have to address that.

Finally, just how big a ‘loophole’ is it? It’s now been 17 years since A-day, and those individuals who have enhanced protection with tax-free cash protection and haven’t fully crystallised their benefits are a fast-dwindling number. Maybe, HMRC just took the view that in practice only a handful of people will realise that they could take more tax-free cash and decided to ‘take the hit’.