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Lump sum and death benefit allowance

With the abolition of the lifetime allowance (LTA) from 6 April 2024 came the introduction of two new allowances which limit tax-free lump sums paid from registered pension schemes – the lump sum allowance (LSA) and the lump sum and death benefit allowance (LSDBA).

The LSA is a limit on certain lump sums paid during the member’s lifetime, whereas the LSDBA also includes certain lump sums paid on death before age 75 and serious ill-health lump sums paid before age 75. 

The standard LSDBA is £1,073,100 for those without transitional protection or enhancements.

When calculating the available LSDBA when a relevant lump sum is to be paid, any relevant lump sums previously taken since 6 April 2024 should first be deducted. Transitional rules apply where benefits have been taken before 6 April 2024 – more on this later.

Unlike the pre-6 April 2024 rules, there will be no difference in the taxation of lump sum death benefits paid from crystallised or uncrystallised funds. The exceptions to this rule are lump sum death benefits from funds crystallised before 6 April 2024 – these are ignored for LSDBA purposes. 

Lump sums within the available LSDBA will normally be paid tax-free. Those paid in excess of the available LSDBA will normally be subject to income tax.

Which lump sums count towards the LSDBA?

The following lump sums are ‘relevant benefit crystallisation events’ (RBCEs) and count towards the LSDBA:

• Pension commencement lump sums (PCLS) – the whole of the PCLS counts towards the LSDBA. This includes scheme-specific tax-free cash, where the PCLS is greater than 25% of the total value crystallising.
• The tax-free element of an UFPLS payment – an ‘uncrystallised funds pension lump sum’ is a way to take money purchase pension funds as a lump sum (or series of lump sums) without having to buy an annuity or go into drawdown.
• Stand-alone lump sums – the tax-free element is limited to the value that could have been paid on 5 April 2023. Only the tax-free element counts towards the LSDBA.
• Serious ill-health lump sums – where life expectancy is less than a year, it may be possible to pay uncrystallised benefits as a tax-free lump sum - but only if paid before age 75.
• Lump sum death benefits – on death before reaching age 75 and paid within two years of the scheme administrator being made aware (or could reasonably have been expected to be aware) of the member's death . However, there are some exceptions…..

Which lump sums don’t count towards the LSDBA?

The following lump sums can be ignored for the purposes of the LSDBA:

• Lump sum death benefits from funds crystallised before 6 April 2024. Of course, any tax-free cash taken by the member when the benefits were crystallised will be taken into account.
• Trivial commutation lump sums – where a lump sum is paid to a member of a defined benefit scheme because their overall pension entitlement, from all schemes, is deemed trivial - £30,000 or less.
• Trivial commutation lump sum death benefits – where a lump sum death benefit is paid to a dependant from a defined benefit scheme because the value, under that scheme,  is £30,000 or less.
• Winding up lump sums – where a lump sum is paid from an occupational pension scheme because the scheme is being wound up and the accrued benefits are deemed trivial - £18,000 or less. This also applies to winding up lump sum death benefits.
• Small pot lump sums – where the value of the arrangement is £10,000 or less.
• Charity lump sum death benefits - on death before age 75, lump sums paid to charity are not tested against the deceased's available LSDBA so long as there are no dependants and the member had nominated the charity.
• After the two year period – lump sum death benefits paid more than two years after the scheme administrator was made aware (or could reasonably have been expected to be aware) of the member's death.
• Post 75 - Lump sums death benefits where the member died after reaching age 75, or serious ill-health lump sums paid after reaching age 75.

Transitional protections

The LSDBA differs for those with transitional protections:

Enhancement factors

Primary protection factor aside, it's possible for an individual to apply for an enhancement factor that will give an added amount to their LSDBA in three other circumstances – but only where the event happened before 6 April 2024:

• Where an individual receives a pension credit on divorce, which has already been tested against the LTA of the former spouse - apply using form APSS 201.
• Where benefits from a recognised overseas pension scheme (ROPS) have been transferred into a UK registered pension - apply using form APSS 202.
• Where contributions have been made, or benefits accrued under a UK registered pension for a 'relevant overseas individual' and no UK tax relief was available - apply using form APSS 202.

The deadline for applying for an enhancement is 5 April 2025.

Some individuals may already have enhancement factors which would previously have increased their LTA.

The enhancement will apply to any RBCEs except the payment of pension commencement lump sums (PCLS) or uncrystallised funds pension lump sums (UFPLS) – i.e. they don’t increase the member's LSA.

Calculating the factor

The uplift for any enhancements is calculated by dividing the extra benefits (e.g. pension credit) by the standard LTA for the tax year in which they were acquired. If the individual had any of the fixed protections or individual protections in place at that time, their protected LTA replaces the standard LTA in the calculation.

The factor is rounded up to two decimal places.

(Note that, when the regulations abolishing the LTA were originally introduced, they stated that if applying for an enhancement after 5 April 2024, the extra benefits would be divided by £1M to calculate the enhancement factor - this has since been amended and backdated). 

Applying the factor

An individual with an enhancement factor will have their normal LSDBA plus an additional amount calculated by multiplying the factor by the LSDBA. Their LSDBA will simply be calculated as:

LSDBA + (LSDBA x enhancement factor)

If the individual has a larger LSBDA than the standard, because of pre-6 April 2024 protections, then their protected figure replaces the LSDBA.

Benefits taken pre-6 April 2024 – remaining LSDBA

Where benefits have been taken before 6 April 2024, an adjustment to the available LSDBA must be made to account for lump sums already paid.

Transitional rules offer two possible ways to do this.

Standard calculation – LTA usage

When testing against the LSDBA, the standard calculation will normally deduct 25% of the LTA used by benefits taken before 6 April 2024, even in situations where no tax-free cash was taken. This is the default option.

If a serious ill-health lump sum has been paid then 100% of all LTA usage (i.e. not just the serious ill-health lump sum) should be deducted from the individual’s LSDBA.

If 100% of the LTA has been used up, the LSA and LSDBA will be set to £0 for the standard calculation. For this reason, it may be beneficial for some individuals to use the alternative method to improve their LSDBA position, even if it won’t produce any more tax-free cash for the member.

If pension benefits came into payment before 6 April 2006 (i.e. pre-A-Day) but there were no BCEs from 6 April 2006 to 5 April 2024, the pre-A-Day pension has to be valued to see how much of the LSA and LSDBA has been used up. This is calculated as 25 times the annual pension in payment at the first RBCE.

Alternative calculation - transitional tax-free amount certificate (TTFAC)

The transitional rules provide for an alternative calculation that can benefit some individuals by increasing their remaining LSA and LSDBA and, therefore, allow greater tax-free lump sums than under the standard calculation.

This option is there for individuals (or on death, their legal representatives) who can evidence the exact amounts of tax-free lump sums paid before 6 April 2024. This then allows them to apply for a ‘transitional tax-free amount certificate’ (TTFAC) confirming the aggregate amount to be deducted from their allowances.

Clients who potentially could obtain higher allowances by successfully applying for a TTFAC include those who:

• took low or no tax-free cash because their scheme had generous guaranteed annuity rates
• were in DB schemes but didn’t commute pension for their full tax-free cash entitlement
• took benefits during the four tax years when the LTA was lower than £1,073,100 (i.e. 2016/17 to 2019/20)
• transferred uncrystallised benefits to a QROPS – LTA will have been used up without any tax-free cash being paid
  
• took benefits from a scheme including disqualifying pension credits in respect of pension sharing
• are over age 75 and have ‘unused funds’ (i.e. where they haven’t taken benefits yet). These funds will have been tested against, and used up, some of their LTA, so if the standard calculation will deduct 25% of the LTA used from their available LSA, a TTFAC could help

Just because one of the above applies to a particular scheme, it doesn’t necessarily mean that the client will have greater allowances using this method – the overall lump sums to be deducted needs to be compared to what would be deducted under the standard calculation. For example, someone may have taken less than 25% tax-free cash from one scheme, but also took 25% tax-free cash from another scheme when the LTA was much higher – the standard calculation could possibly result in higher available LSA and LSDBA.

For individuals who have used up 100% of the LTA, their LSA and LSDBA will be set to £0 under the standard calculation. For this reason, it can make sense for those in this position to apply for a TTFAC to improve the LSDBA position, even if it won’t produce any more tax-free cash for the member. If there’s a possibility of death benefits being paid as a lump sum, it seems like an obvious thing to do.

If pension benefits came into payment before 6 April 2006 (i.e. before A-Day) but there were no BCEs from 6 April 2006 to 5 April 2024, it will not be possible to use this alternative calculation – the default standard calculation will apply.

Applying for a TTFAC

The TTFAC is required before the first RBCE from 6 April 2024, otherwise the standard calculation will apply. So, for clients intending to take benefits soon, it’s crucial to start gathering information as soon as possible to avoid losing out or having to delay taking benefits.

Individuals with registered tax-free cash rights under enhanced or primary protection cannot apply for a TTFAC.

Obtaining the details of tax-free cash taken many years ago could prove difficult – maybe even impossible for some.

The application can be made to any scheme of which the individual is a member. In practice, it’s expected that most individuals will apply to the scheme which will pay the first lump sum after 5 April 2024. If the member has died, the personal legal representatives can apply for the TTFAC.

The scheme administrator will have three months to either supply the TTFAC or explain why they’ve refused to issue it.

Once a TTFAC has been issued, it then supersedes the standard method. The TTFAC cannot be revoked by the member, even if the certified amount is actually lower than the amount calculated under the standard calculation. So it’s important to check before applying!

The importance of death benefit options

The introduction of the LSDBA further strengthens the case for being in the right scheme.

As the name suggests, only lump sum death benefits are tested against the LSDBA. And on death before age 75, lump sum death benefits paid in excess of the available LSDBA are subject to income tax at the beneficiary’s marginal rate.

However, any death benefits paid as a pension are not tested. So, on death before age 75, beneficiaries who choose beneficiary's drawdown can draw as much as they want, when they want, tax-free.

Ensuring that clients are in a scheme which gives all the death benefit options can therefore be crucial for individuals with significant pension savings.

It’s also important to ensure that death benefit nominations are in place and up to date - particularly where death benefits could be paid to non-dependants. If a non-dependant beneficiary has not been nominated, the only option will be a lump sum if there is a surviving dependant or someone else who has been nominated.

Nominations aside, there may still be situations where a lump sum death benefit is unavoidable, or the preferable option. For example:

• an overseas beneficiary where the scheme provider will only allow drawdown for UK residents
• death-in service benefits will be paid as a lump sum
• a lump sum to a trust is required to retain some control access to the benefits for a vulnerable beneficiary