Tax Doctor: maximising the cash taken from a pension

The case:

Jack is aged 64. He wants to retire next June and take his pension benefits. He has a SIPP worth £1.1 million and a small defined benefit scheme which promises to pay out £2,000 a year income. (He has no protection.)

He is over the lifetime allowance, but he understands it is being abolished. He wants to understand better what his choices are next year, and how he can maximise the cash he takes.

The diagnosis:

Jack’s financial adviser explains the changes to the pensions tax rules will be introduced over two years. For this tax year – 2023-24 – there is no longer a lifetime allowance tax charge. That means if Jack takes his excess pension benefits over the lifetime allowance this year as income there will be no additional charge. If he takes them as a lump sum, then there will be an immediate charge to income tax.

The situation, though, changes again next tax year. HMRC is currently consulting on the draft rules.

The basis of the new rules is to remove the lifetime allowance. Under the new regime there will no longer be any test against benefits taken as an income. But there will be two new tests for lump sums. The first – the Lump Sum Allowance (LSA) – measures the tax-free lump sums taken, for example as pension commencement lump sum (PCLS) and the tax-free part of an uncrystallised funds pension lump sum (UFPLS). That is set at £268,275.

The second – the Lump Sum and Death Benefit Allowance (LSDBA) – measures the LSA plus any lump sums taken when the member dies (or takes benefits because of serious ill health).  That is set at £1,073,100.

The maximum tax-free lump sum that can be taken will be the lower of:

• 1/3rd of the funds taken to provide an income;
• the remaining LSA; and
• the remaining LSDBA.

So far, this seems like ‘smoke and mirrors’ allowing pension scheme members to still take 25% of their funds as tax-free cash. The new rules have been crafted to create the same tax position for pension scheme members as this tax year, but without the lifetime allowance tests.

But it’s worth noting there is no rule that income must be taken – only that if it is, then the maximum tax-free cash is 1/3rd of its value. If no income is taken, then the maximum tax-free cash available is zero (1/3rd of nothing is nothing). The new rules don’t stop the whole amount being taken as taxable cash.

This represents nothing new for defined contribution funds – after all the same effect can be achieved if the member encashes their whole drawdown. But it could mean big changes for defined benefit schemes.

This is because if a pension scheme member takes a lump sum over the £268,275 today, then the excess would be an unauthorised payment. This would have serious tax implications for both the member and the scheme, and so scheme rules generally don’t allow it. But from 6 April 2024, HMRC has proposed the excess is taxed as income.

Next year, Jack could use up his LSA by taking £268,275 as PCLS from his SIPP and designating the rest to drawdown (where it will be taxed when taken as income.

As he can’t get any more tax-free cash, he could, theoretically, take his whole defined benefit scheme as a lump sum, and it will be subject to income tax. After all, Jack, would get limited benefit from receiving £167 a month and would prefer the lump sum.

There are two important caveats. First, most scheme rules would have to change to allow this. Some schemes might choose to do that, others wouldn’t. Second, these are only draft proposals from HMRC, and it may decide to change them.