Transitional Tax-Free Amount Certificates – proceed with caution

The basic premise of the new pension rules coming in from April is very simple – only lump sums are tested. We have a new Lump Sum Allowance (LSA) that restricts tax-free lump sums in life and the Lump Sum and Death Benefit Allowance (LSDBA) that restricts lump sum death benefits (and serious ill health lump sums). For those who have not yet accessed benefits and will only do so under the new regime, calculations are simple, and once your allowance is used up, it’s used up.

Where things have been overly complicated by HMRC are the transitional arrangements.

Understandably, those who have already taken some PCLS under the current rules will have a reduced LSA after 6 April. There is a standard transitional calculation that is applied when the member first comes to take a tax-free lump sum under the new rules. This makes sense, as otherwise people would get two bites at the tax-free cash cherry.

The standard calculation assumes that 25% PCLS has been taken from all benefit crystallisation events, so reduces the available LSA by 25% of the lifetime allowance (LTA) used.

For example, Chris has used 60% of LTA. When he takes his first lump sum under the new rules his LSA is reduced from the standard £268,275 to £107,310 (£268,275 less (25% x 60% x £1,073,100)).

If Chris took his PCLS before 6 April 2024 he would be able to take 25% of his fund up to the available LTA. With 40% LTA remaining this would be 25% of 40% of £1,073,100 – i.e. £107,310 – so he’s in exactly the same position.

What I don’t understand, is why HMRC didn’t just leave it there for everyone. As they state in their own lifetime allowance guidance newsletter released in February “no one will be put in a worse tax position by the standard transitional arrangements than they would have been under the lifetime allowance system.”

Instead, the new legislation introduces opportunities for clients to apply for a transitional certificate in an unexpected – and frankly unnecessary – tax-free cash giveaway for some.

If Chris had taken his benefits by accessing a defined benefit pension, and opted not to commute any of his scheme pension for a lump sum, he could apply for a certificate. Instead of assuming 25% PCLS has been taken, the transitional certificate deducts the actual amount of PCLS taken from the standard LSA. So, if Chris hadn’t taken any PCLS under his DB scheme, he would have the full £268,275 available after 6 April 2024.

If Chris has uncrystallised pensions of £429,240 (4x £107,310) or more, it will be worth him applying for the certificate to get more tax-free cash. There are other cases that will be more nuanced though.

Take Linda who crystallised her DB pot back when the LTA was £1.5 million. She crystallised £1.2 million (using 80% of the LTA), but only took 20% of that as PCLS – £240,000. At first glance you may think she would get more LSA by applying for a certificate as she didn’t take the full 25% PCLS. However, under the transitional calculation (25% x 80% x £1,073,100) her LSA is reduced by £214,620, whereas with a certificate the reduction is £240,000 – so she’d be worse off applying for a certificate.

If Linda had instead used 80% of the LTA when it was £1.25 million, 20% PCLS would have been £200,000. In this instance the certificate would give a higher LSA, as it would be calculated as £268,275 less £200,000 giving £68,275. If she had uncrystallised funds of more than £273,100 (4x £68,275) then she’s better off applying.

Another anomaly in the new rules is that age 75 benefit crystallisation events aren’t ignored. This means that clients who have reached aged 75 without taking all their PCLS will find their LSA significantly reduced. In nearly all cases they will have a higher LSA if they apply for a certificate – as they won’t have taken any PCLS at age 75 but the standard calculation assumes that they will. Under current rules the age 75 test is ignored when calculating PCLS, but the new legislation has no provision for this. This seems an oversight and could easily be corrected by regulations to prevent a large portion of this group needing to apply for certificates. Of course, if the LSA under the standard calculation is higher than 25% of the uncrystallised fund, then there is no benefit in applying.

The decision to apply for a certificate should not be taken lightly, because once applied for the decision is irreversible. The rules state that if the member sends the scheme administrator complete evidence of lump sums previously taken, then they must issue the certificate. Once a certificate has been issued the scheme cannot ignore it.

HMRC’s February newsletter confirms this point and goes on to say “…the legislation does not allow for members to apply in order to compare the results under each process.”

So, while the new certificates will certainly benefit a number of clients, a blanket approach should not be taken. Each case will need to be assessed individually to ensure that the certificate puts the client in a better position.