Untangling the knots: tax-free lump sums under Primary Protection and Enhanced Protection

When the lifetime allowance was swept away on 6 April 2024, we moved into a new pensions regime. However, we are still dealing with relics from the previous regime, and even the regime before that.

In this article, I’ll look at how you calculate the maximum pension commencement lump sum (PCLS) for clients with defined contribution pensions holding enhanced protection and primary protection. If you’ve got one of these cases on your desk that you’ve been putting off and putting off, this article will hopefully help.

Standard PCLS calculation

Before we look at protection rules, let’s recap the standard PCLS calculation. The maximum PCLS is the lower of:

• 25% of the funds being crystallised;
• available Lump Sum Allowance (LSA); and
• available Lump Sum and Death Benefit Allowance (LSDBA).

In practice, the available LSA will almost always be lower than the available LSDBA. The only lump sum a client can take during their lifetime that reduces the LSDBA and not the LSA is a serious ill-health lump sum.

For most people, the LSA is £268,275 and the LSDBA is £1,073,100.

Enhanced Protection (EP)

For clients holding EP, the maximum PCLS is the lower of:

• 25% of the funds being crystallised; and
• available LSA.

Unlike the standard calculation, note that the LSDBA does not limit PCLS in this scenario. It’s not clear why this is the case, but that’s how the legislation is written.

The LSA for a client with EP is £375,000.

Enhanced Protection with lump sum protection

It gets more complicated when the client holds EP with a protected lump sum. As a reminder, the protected lump sum under EP is expressed on the protection certificate as a percentage.

Under the new regime, the maximum PCLS is the lower of:

• protected percentage of the funds being crystallised; and
• protected percentage applied to the uncrystallised fund value at 5 April 2023 (minus any PCLS paid from that fund since that date).

While the new regime started on 6 April 2024, this looks back to the uncrystallised fund value on 5 April 2023.

This can be confusing, not least because the available LSDBA for these clients is based on the uncrystallised fund value at 5 April 2024.

It was from 5 April 2023 that clients holding enhanced protection (and fixed protection) could start making contributions or have benefit accrual – something that would previously have revoked their protection.

This was one of a couple of interim changes introduced in 2023 in advance of the main changes in 2024.

It was because of this new ability to build up pension funds from 6 April 2023 that the legislation looks back to 2023.

Primary Protection (PP)

For clients holding PP, the maximum PCLS is the lower of:

• 25% of the funds being crystallised;
• available LSA; and
• available LSDBA.

The LSA for a client with PP is £375,000.

The LSDBA is £1,800,000 plus £1,800,000 multiplied by the PP enhancement factor.

For example, a PP factor of 0.65 would give you a protected LSDBA of £2,970,000.

Primary Protection with lump sum protection

Again, complication abounds with protected lump sums. Under PP, the protected lump sum is expressed on the protection certificate as a monetary amount.

The maximum PCLS is calculated as the monetary amount, multiplied by 1.2 and minus any PCLSs paid since 6 April 2006.

Previous PCLSs paid before 6 April 2012 are revalued by multiplying the PCLS amount by £1,800,000 and dividing by the standard LTA at the time.

The PCLS can exceed available LSA, so the LSA is ignored for these clients.

The LSDBA is calculated the same way as in the previous section. A PCLS isn’t limited by available LSDBA. However, the legislation says a client must have some LSDBA in order to receive the PCLS.

As a further wrinkle, it’s worth noting that that there is no 25% crystallisation requirement. There must still be some funds designated to provide an income (e.g. income drawdown, lifetime annuity) alongside the PCLS, but it can be any amount.

For example, let’s say the protected lump sum is £400,000 and the current uncrystallised fund value is £500,000.

The maximum PCLS = £400,000 x 1.2 = £480,000.

The client could crystallise the whole pension, taking a PCLS of £480,000 and designating £20,000 into drawdown.

More transitional woes

One final word. If your client took pension benefits before 6 April 2024, there will be transitional calculations to do in order to account for those previous benefits.

If they have a protected PCLS, however, previous lump sums are effectively accounted for in the calculations we’ve covered, so there is no transitional calculation, just to add a further wrinkle.

So all in all, it’s a knotted mess. But hopefully those awkward cases now seem slightly less daunting.