Techzone

The abolition of the LTA has removed a huge barrier to pension saving. There are now caps in place to limit tax-free cash and tax-free lumps sums on death, but the LSA and LSDBA shouldn’t been seen as a ceiling on how much can be saved for retirement.

Funding in excess of the amount that would provide the maximum tax-free cash will simply mean there’s no further tax-free cash available on those savings – there’s no tax charge for exceeding the allowance. If the rate of tax relief the client receives on the contribution mirrors the rate of tax payable on their retirement income, funding above the allowance will effectively provide the same return as an ISA.

There are compelling reasons for those clients at or above the limits to continue funding. A £60k annual allowance plus an opportunity for those with enhanced or fixed protection to resume funding without compromising their higher TFC entitlement creates additional scope to save more for their retirement.

What incentivises clients to save into pensions over other forms of saving?

The main reasons include:

• Tax relief at highest marginal rate, with benefits taxed at potentially lower rates in retirement.
• Tax-free cash on withdrawals.
• Security for loved ones – death benefits are paid free from IHT.

How do the new allowances affect these?

Generally speaking, they don't.

Tax-free cash is limited by the ‘Lump Sum Allowance’ (LSA), which is currently the same as 25% of the old LTA. But there are no further charges when benefits are taken other than income tax.

On death before age 75, the ‘lump sum and death benefits allowance’ (LSDBA) limits the amount of lump sum death benefits that can be paid tax-free, but tax can easily be avoided if the death benefit can be taken under drawdown or by purchasing an annuity.

Therefore, without the threat of additional charges based on overall pension wealth, one of the main barriers to continued funding has been removed.

With the new regime comes new funding opportunities

When clients take their retirement benefits, they no longer have to factor a charge because of how much they have saved. Tax-free cash may not be generated by new contributions but, even then, clients could still be better off.

High net worth clients with either enhanced or fixed protection can recommence savings if they have not already done so without fear of losing those protections, provided they were in place on 15 March 2023. These protections are still valuable as they give a higher LSA and LSDBA.

Where fund values are below the relevant fixed protection limits, new funding can also generate more tax-free cash, up to their protected LSA. There is also an opportunity for those with fixed protection who have had their pension pots diminished by a sharing order on divorce to rebuild their pots and tax-free cash.

Some clients who had taken benefits before 6 April 2024 may be able to generate more tax-free cash by applying for a transitional tax-free amount certificate (TTFAC) - for example, if they had taken less than 25% tax free cash on crystallisation, or had taken benefits when the LTA was less than £1,073,100. Clients must have enough uncrystallised funds to be able to do this and, if they do not, this can be the motivation for additional contributions.

The economic argument for pension savings

When saving for retirement, a pension will in most cases provide better net returns than an ISA, purely based on the tax mechanics. Both enjoy tax free growth, but ignoring this, the pension outcomes will depend on three factors – tax relief on the way in, the tax rate on income withdrawn, and the availability of tax-free cash.

While individuals can now save without being penalised for the size of their funds, new savings may not attract any further tax-free cash. Despite this, a pension can still be a favourable option provided the tax rate when benefits are taken is not greater than the rate of tax relief received when contributions are made.

The table looks at a sample of pension returns on a gross contribution of £1,000 where the rate of tax relief on payments in is greater or equal to the income tax on withdrawals, and with and without tax-free cash:

This confirms that where tax-free cash is available, there is a positive return even where the tax rate on withdrawal equals the rate of tax relief given on contributions.

The same is true even where no tax-free cash is available if the tax rate on withdrawal is less than the rate of tax relief given.

Where the tax rate on withdrawal is the same as the rate of tax relief on the contribution and there is no tax-free cash available, we get a neutral outcome. This scenario mirrors the returns from an ISA. But there are still arguments in favour of a pension being the preferred choice for retirement savings:

• Pensions are generally IHT free, and therefore more attractive when transferring wealth to the family.
• Pension savings can be passed on via inherited drawdown, which means that chosen beneficiaries can continue to hold their inheritance in a tax favoured wrapper. Only a spouse or civil partner can 'inherit' an ISA with its tax benefits intact.
• Where pension savings are inherited on death after reaching age 75, they will be taxed at the beneficiary's marginal rate of income tax, which may be lower than the member's own tax rate. If the member dies before age 75, there may be no income tax at all.

The opportunity – how much?

The maximum annual allowance for the current year is £60,000. Unused annual allowances from the last three tax years can also be carried forward, allowing up to £200,000 to be paid in. Individuals would need to have enough earnings to justify the tax relief on the gross contribution. However, higher rates of relief may be achieved by spreading the contribution over more than one tax year.

The same opportunity arises to those who had simply decided to stop contributions because they were concerned that the value of their savings may exceed the LTA.

In addition to tax relief, such large contributions may also reduce threshold income to below the £200,000 limit so that the annual allowance is not tapered. Similarly, reducing adjusted net income (ANI) to below £125,140 will restore some or all of the personal allowance (personal allowance is fully restored if ANI is less than £100,000). Both indirectly increase the effective rate of tax relief for saving into a pension.

Business owners

The main rate of corporation tax is now 25%. Alongside the NI savings, the higher rate of relief on employer contributions will be more attractive to directors as a means of taking profits from their business. Provided they are not part of any contractual sacrifice arrangements, such payments don't count towards threshold income, though would increase adjusted income. (See our insight article ‘The tricky business of profit extraction’ which considers in more detail the best way for business owners to take profits).

Self-employed entrepreneurs are now taxed on their profits arising in the tax year. This does not leave much time to decide how much to pay into pensions in the same tax year if accounts have not been finalised – forecasts may have to be relied upon to some extent.

However, where clients have chosen to ‘spread’ the taxation of transitional profits from the 2023/24 transitional tax year, these transitional profits will also boost UK relevant earnings and facilitate a higher contribution – or at least provide a margin of comfort where profit forecasts are being used.

The future

Concerns have been raised over what a Labour Government might do if elected at the next General Election.

Advisers can only advise on the rules as they currently stand. Avoiding taking action based on speculation on what might happen could lead to missed opportunities. Historically, successive UK governments have not applied retrospective change to pension policy penalising actions to date. That's been true of all political parties that have been in power.