Pension tax-free lump sums

In short:

• There is a maximum monetary amount that you may take as tax-free lump sums in your lifetime; anything else taken being taxed as income
• There is a maximum monetary amount of tax-free lump sums that can be paid on your death before age 75; any lump sums over that being taxed as beneficiaries’ income
• But, by way of a simple but essential nomination, beneficiaries are able to drawdown on any and all of your pension funds as income, free of tax – on your death before age 75.

The lifetime allowance – Gone but not forgotten

6 April 2024 saw the abolition of the lifetime allowance and, with it, a UK tax ‘surcharge’ on UK pension retirement and death benefits in excess of the lifetime allowance.

Ahead of the July 2024 General Election, the Labour Party let it be known that it does not intend to reintroduce the lifetime allowance. However, its manifesto included a promise to review pensions. Our report is based on our understanding of current legislation and HMRC guidance.

The lifetime allowance served as the reference point for myriad aspects of UK pensions, not least the extent to which retirement and death benefits might be exempt from UK tax. From 6 April 2024, that role is now provided by two new allowances:

• Lump sum allowance (LSA) – being the aggregate amount of ‘tax free cash’ you may draw from your pension funds in your lifetime; and
• Lump sum and death benefit allowance (LSDBA) – being the maximum aggregate amount of your pension fund that can be paid as tax-free lump sums on your death before age 75. The LSDBA is reduced by any ‘tax free cash’ taken by you in your lifetime.

Unsurprisingly, your new LSA and LSDBA available from 6 April 2024 are a direct function of your lifetime allowance on 5 April 2024 – and intended, of course, to generally give the same tax-free outcome.

Any payment that is not tax free is simply taxed as income in the hands of the recipient.

The starting point is your lifetime allowance as at 5 April 2024, be it the standard or one of myriad ‘protected’ lifetime allowances:

• The standard lifetime allowance was £1,073,100 which potentially leads to:
• A LSA of £268,275; and
• A LSDBA of £1,073,10
• If you hold Fixed Protection 2016 and, so, a lifetime allowance of £1,250,000, potentially:
• A LSA of £312,500 and
• A LSDBA of £1,250,000
• Fixed Protection 2012 and 2014, providing lifetime allowances of, respectively, £1,800,000 and £1,500,000 likewise lead to potentially higher LSA and LSDBA
• Individual Protection 2016, Individual Protection 2014, Enhanced Protection and Primary Protection all set LSA and LSDBA in their own way but require more personal analysis to work those out

Fixed Protection 2016, and the higher LSA and LSDBA, is still available if no pension contributions have been paid by or for you since 5 April 2016 or, in the case of membership of a final salary/defined benefits pension scheme, there has been no ‘benefits accrual’ since 5 April 2016. You have until 5 April 2025 to apply.

Might your allowances be higher?

Your potential LSA and LSDBA at 6 April 2024 – e.g. £268,275 and £1,073,100 – are reduced if you have taken any retirement benefits before 6 April 2024, using up some or all of your lifetime allowance in the process. If you have, it is automatically assumed that you previously received a tax-free lump sum equivalent to 25% of the lifetime allowance used up at the time. Your LSA/LSDBA are reduced accordingly. If, in practice you received less tax free then you are able to have that applied instead by requesting a ‘Transitional Tax-Free Amount Certificate’.

But beware: you must apply for the TTFAC Certificate before you take any more retirement benefits post 5 April 2024; and, indeed, it might not give you the result you expect. Check the numbers carefully before applying to make sure the TTFAC does not result in less tax-free cash – once done, a TTFAC cannot be undone.

An example:
Arlo took a public sector pension in January 2016, receiving:

• A pre-tax pension for life of £20,000; plus
• A tax-free lump sum of £60,000.

The deemed lifetime allowance value of these is £460,000 and will have been certified by the pension scheme at the time as using up 36.80% of the then £1,250,000 lifetime allowance.

Arlo went on to work elsewhere, joining the new employer’s workplace pension scheme with contributions being paid after 5 April 2016. Arlo is not eligible for FP16 and the standard lifetime allowance of £1,073,100 applied at 5 April 2024.

That provides a potential LSA of £268,275. It is reduced automatically by:

25% of 36.80% of £1,073,100 = £98,725

Being the supposed tax-free cash taken in January 2016 and giving an initial LSA of £169,550. Which would have been the same amount available anyway under the previous lifetime allowance -based system.

Arlo still has the letter setting out the January 2016 benefits and can prove the amount of tax-free cash received – £60,000. Arlo may now apply for a TTFAC Certificate such that the LSA is reduced to only £208,275.

It remains the case that the maximum amount of tax-free cash that you can take when you crystallise part of a pension fund is 25% of the amount so crystallised. So, if Arlo has another £1m as yet uncrystallised fund and decides to crystallise £300,000, the maximum lump sum is the lower of:

• 25% of £300,000 crystallised £75,000; and
• LSA available £208,275

So, £75,000 can be taken as a tax-free lump sum, reducing the LSA to £133,275.

If Arlo subsequently crystallises the remaining £700,000, the maximum lump sum from that is:

• 25% of £700,000 crystallised £175,000; and
• LSA available £133,275

So, £133,275 can be taken as a tax-free lump sum, fully exhausting the LSA.

It is worth noting that had Arlo taken less that £75,000 at the first crystallisation – £40,000, say – the LSA available at the second time would be £173,275. That is, for those with larger pension funds were the LSA might bite on the 25% allowance, taking less than 25% is not necessarily a loss of eventual lump sum.

Whereas the old lifetime allowance was a more ‘use it or lose it’ approach to the 25% allowance.

On your death

UK pension funds are not ordinarily a focus for UK inheritance tax. Although HMRC will investigate transfers of pension funds or other ‘unusual’ transactions that occur in the two years before death, should the individual have been in poor health at the time.

That is not to say that UK pension funds are tax-free on death. They may well be taxed, but it is not Inheritance Tax as such.

On your death, your remaining UK pension fund – whether crystallised or as yet uncrystallised can be:

• Paid out as a lump sum; and/or
• Designated to a dependant’s or nominee’s drawdown account.

Lump sums

Lump sums can be paid out to any individual that the pension scheme administrator considers eligible.

The pension scheme administrator will ask for details of surviving spouse, children, grandchildren, parents, grandparents etc. and of anyone else who might have been financially reliant on the deceased.

They will also consider anyone named in the deceased’s will and anyone the deceased nominated to the pension provider.

Lump sums will be:

• Tax-free if you die before age 75, are settled within two years of death (otherwise taxed) and, in aggregate, are within your LSDBA
• Taxed as the beneficiaries’ income if you die before age 75 and are in excess of your LSDBA
• Taxed as the beneficiaries’ income if you die at or after age 75.

Dependant’s and nominee’s drawdown accounts

Any pension fund not paid as a lump sum on your death can be designated to an income drawdown account, being:

• Dependant’s drawdown for your surviving partner
• Dependant’s drawdown for a child of yours age under 23
• Nominee’s drawdown for anyone you have nominated in writing to the pension provider as a potential beneficiary on your death.

For the avoidance of doubt, a nominee’s drawdown account can only be offered to someone who has been so nominated by you. Unless, that is, you leave no partner or other dependant. If anyone else is to be offered a nominee’s drawdown account, it is essential that you lodge a written nomination with the pension provider

The initial designation of the fund to a dependant’s or nominee’s drawdown account does not count towards or use up any of your LSDBA.

The beneficiary of a dependant’s or nominee’s drawdown account is free to take withdrawals as and when they wish, regardless of age. That is, a nominee does not have to wait until age 55 (the current minimum age to access their own pension plan) to do so. Except that is, a dependent child who was designated a dependant’s drawdown account by virtue of being under age 23 (rather than as a nominee) who may take withdrawals up until that age but must then wait to age 55 (or other standard minimum retirement age) to make any further withdrawals.

Withdrawals for a dependant’s or nominee’s drawdown account are:

• Tax-free if you die before age 75, and your fund has been designated to dependant’s or nominee’s drawdown within two years of your death; otherwise, subject to UK Income Tax
• Subject to UK Income Tax where you die at or after age 75

Where you die before age 75 and where a prospective beneficiary is looking to receive immediate payment, the lump sum option will be suitable – to the extent that any lump sum is within your LSDBA. It will be free of UK tax. If they wish to defer receiving all or some of the money and, certainly, where the fund is more than your LSDBA (and would be subject to UK Income Tax if paid as a lump sum), that part should be first designated to dependant’s or nominee’s drawdown. The dependant or nominee is then able to take as much as they want, free of UK tax where you had died before age 75.

How we can help

Our pensions team can help you to understand your situation and work out your LSA and LSDBA.

We can also guide you on applying for FP16 and, so, a possible increase in both allowances. Similarly, we can work out if you have taken less than the 25% default tax-free lump sum on pre-6 April 2024 retirement claims and whether you should apply for a Transitional Tax Free Allowance Certificate. Finally, we can also guide you on nominations.

If you have any questions about the above, please get in touch with your usual Blick Rothenberg contact or with our pensions team using the form below.

Disclaimer:

This article is intended to give you an insight into the tax treatment of pension withdrawals taken by you in your lifetime or, on your death, your successors. Please note, it has been written for information only and should not be relied upon in assessing your own situation.