The transition into the new pension regime

With just a few months to go before the Lifetime Allowance (LTA) is abolished from the pension tax rules, we now have the full draft rules of how the new regime will work.

Back in last year’s Spring Budget the Chancellor announced the intention to remove the LTA from April 2024, and since then we have had various drafts of legislations amending and creating new rules. Broadly speaking, under the new rules pensions from next tax year will only be tested against a limit when they are paid as a lump sum. The new Lump Sum Allowance (LSA) will cap tax-free cash from pensions paid during someone’s lifetime and the Lump Sum and Death Benefit Allowance (LSDBA) will limit tax-free lump sum payments following a member’s death. But there will be no limits where funds are designated to provide an income, be that in the member’s lifetime or on their death if the beneficiaries receive an income from their share, rather than a lump sum.

One of the unknowns before the latest draft Finance Bill was how the previous rules will interact with the new. This is particularly relevant for clients holding uncrystallised funds on 6 April 2024 having also taken benefits in some form before that point using up a percentage of LTA under the old system. There will be a set of transitional provisions for pre-24 benefits, in which the available amount of LSA and LSDBA under the new system will be reduced based on the LTA previously used.

The LSA will be reduced by 25% of the LTA used. (However, where someone has used 100% of their LTA before 6 April 2024, their LSA will be nil).

For example, if 50% of the LTA has been used, the amount of LSA will be reduced by 12.5% (25% of 50%) of £1,073,100, i.e. £134,137.50. So available LSA reduces from £268,275 to £134,137.50.

For the LSDBA you deduct:

• 100% of the LTA used for serious ill health lump sums (SIHLS);
• 100% of the lump sum death benefits in relation to a member who died before age 75; and
• 25% of the LTA used.

In the majority of cases where no SIHLS or death benefit lump sums have already been paid, the reduction for the LSDBA will be the same as for the LSA. So, using the previous 50% example the LSDBA would also be reduced by £134,137.50 leaving £938,962.50.

Again, if 100% of the LTA has been used before 6 April 2024, their LSDBA will be zero.

This reduction calculation will take place the first time a client takes benefits on or after 6 April 2024.

This calculation assumes that the individual will have taken 25% of their funds as a pension commencement lump sum (PCLS) or tax-free cash when previously accessing the pension, which might not have always been the case. The new rules contain a provision for an alternative calculation to be applied to individuals who withdrew less than 25% as tax-free cash when their benefits commenced. If they can provide evidence of the specific amount of tax-free cash taken, or confirm that none was taken, they have the option to request a 'transitional tax-free amount certificate.' This certificate will display the amount to be subtracted from their allowances, as opposed to the standard deduction of 25% of the percentage of LTA used.

This could be especially advantageous for clients who chose not to commute any portion of their defined benefit (DB) pension for a lump sum. For example, if a client took no lump sum from their DB scheme but used 50% of their LTA, the standard transitional calculation would reduce their LSA by 12.5%, but with the alternative calculation there would be no reduction in the LSA.

However, it’s important to note that the certificate only increases the amount of allowance. To be able to take additional PCLS, there must still be sufficient funds used to provide an income. The maximum PCLS amount is capped at one-third of the fund used for income provision.

Pension schemes still need clarification on the practical aspects of collecting and substantiating historical information, as well as the responsibilities that providers will bear in issuing certificates. It may be possible for providers to decline; the circumstances under which this is permissible remain uncertain. HMRC will need to provide further guidance to offer additional insights into the evidence-gathering process.

With the imminent abolition of the LTA in the new tax year, understanding the nuances of the new regime is crucial. The draft rules clarify that only lump sum payments will be tested in the future. The interaction between old and new rules is a key consideration, especially for those with both crystalised and uncrystallised funds in April 2024.