Goodbye 55% charge, hello Income Tax

The new pension rules for April 2023 came as a bolt from the blue, giving pension providers and advisers only three weeks to put them into practice.

The headlines were, of course, that there are no more lifetime allowance tax charges, and the lifetime allowance will be abolished completely from April 2024.

The removal of the tax charge should be easy in practice. Previously, on a benefit crystallisation event, if there was an excess above the lifetime allowance, the member would face a lifetime allowance charge of 25% if the funds were taken as income, or 55% if taken as a lump sum. The difference was the income still had to be taxed on withdrawal, and assuming the member was a higher rate taxpayer then the combination of 25% charge then 40% tax equalled a 55% charge.

So it makes sense, if the 25% element of the lifetime allowance charge is removed, then there is still Income Tax to pay on excess paid as lump sums, and this is outlined in the new 2023 rules.

There are four occasions where this may happen. First is when taking benefits as a serious ill-health lump sum. Second and third are when paying out lump sums on death from uncrystallised funds or a defined benefits scheme. And the final one is when paying out any excess as a lump sum when crystallising benefits.

Looking at the last one, SIPP pension schemes may offer members the choice of taking any excess as a lump sum or as drawdown. From April 2023, it makes sense for members to designate not only the funds up to the lifetime allowance as drawdown, but also any funds above the lifetime allowance. Members can always withdraw this amount straight away, but it gives them flexibility to manage the Income Tax charge. The alternative of taking a lump sum means the Income Tax falls due all at once and, unless the provider has a tax code for the member, will be deducted at an emergency rate of tax, meaning the member will overpay and have to claim it back from HMRC.

Lump sums paid out on death are more complicated. Traditionally, on the death of a member providers have paid any lump sums directly to the beneficiary. It was up to the legal personal representative (LPRs) to calculate what, if any, lifetime allowance tax charge was due, and for the beneficiary to pay that to HMRC.

For the new tax year, HMRC originally asked providers to deduct Income Tax due on the excess above the lifetime allowance when they paid out the lump sum. This approach would have meant providers having to ask LPRs for the right information to make the correct tax deduction. In practice, some LPRs may have struggled with this, especially if there were several lump sums due from different schemes, and this could have delayed payment.

HMRC has, however, rolled back on this and will continue to make LPRs responsible for notifying HMRC on how much lifetime allowance has been used. HMRC will then approach the beneficiaries for the Income Tax due.

This is a victory for common sense, and it’s good to see HMRC working with the industry to find the most sensible way forward.

Finally, it’s worth noting the Income Tax charge on the excess will apply if the member was under 75 when they died. This may be complicated for beneficiaries to grasp, after probably being told repeatedly that in this situation benefits are free from Income Tax. The easiest way is for the beneficiary to take the funds as drawdown. That way the whole fund can be paid without any tax charge.

In some situations a lump sum may be unavoidable, for example a death-in-service payment. But for SIPP schemes, making sure nomination forms are up to date should mean beneficiaries have the choice of drawdown or lump sum, and can therefore, if there is an excess on death before age 75, avoid a fiddly Income Tax charge.