Techzone

When the draft rules for the removal of the lifetime allowance (LTA) were first published in July 2023, there were some important missing pieces of the jigsaw. Probably the most crucial amongst them was how tax-free cash taken before 6 April 2024 would affect what could be taken under the new rules.

The Finance Bill has now been published containing further pension changes, including the transitional tax-free cash rules.

For most pension savers, it will simply be the case that their post 5 April 2024 allowances will be reduced by 25% of any LTA they had used before this date. However, there are also rules for those who had LTA and tax-free cash protections, plus new rules which will benefit some who took less than 25% tax-free cash when they took their benefits.

But while we now have the rules for April 2024 and beyond, the practical application of these new rules may take a little longer to be fully formed. HMRC intends to publish guidance in the coming weeks on the implementation of post LTA rules, so things should become a little clearer as more information becomes available.

The new pension allowances

Before we take a closer look at the transitional rules for members' taking tax-free cash, here is a reminder of the two new allowances revealed in July relating to tax-free lump sums that can be paid out during both the member's lifetime and on death:

• Lump Sum Allowance (LSA) - includes pension commencement lump sums (PCLS) plus the tax-free element of UFPLS.
  
  In the initial version of the Bill, the tax-free element of trivial commutation lump sums and winding-up lump sums (and possibly of small pots too) were also included, but these can now be ignored.
  
  The LSA has been set at £268,275 for those without existing LTA protection.
• Lump Sum and Death Benefit Allowance (LSDBA) - LSA amounts plus lump sum death benefits and serious ill-health lump sums. This test will only apply on death before age 75.
  
  The LSDBA has been set at £1,073,100 for those without existing LTA protection.

Higher allowances are available to those with existing LTA protections.

The available LSA or LSDBA when a relevant lump sum is paid on or after 6 April 2024 - to be known as 'relevant benefit crystallisation events' (RBCEs) - will be the allowance less the previously used amounts.

Transitional rules

What was missing from the initial draft Bill were transitional rules for those who have already taken some of their benefits before 6 April 2024. Without further rules, individuals who took benefits when the LTA was higher (i.e. pre 6 April 2016) would be worse off in terms of tax-free cash entitlement.

For those who have previously taken benefits, it has been clarified that there will be two possible methods of calculating the available allowance.

• The standard calculation - 25% of the percentage of LTA used will normally be deducted from the member's LSA.
  
  For example, if someone has used 60% of their LTA before 6 April 2024, their LSA will be reduced by £160,965 (i.e. 25% of 0.6 x £1,073,100).
• The alternative method - this alternative calculation can be used for individuals who took less than 25% tax-free cash when benefits came into payment. If they can evidence the actual amount of tax-free cash taken (or that none was taken) then they can request a 'transitional tax-free amount certificate' showing the amount to be deducted from their allowance, rather than the standard 25% of the percentage of LTA used.
  
  This, for example, could particularly benefit clients who didn't commute any of their DB pension, or took no tax-free cash because they had attractive guaranteed annuity rates. But they'll only be able to take advantage of this change if they have sufficient uncrystallised funds over their remaining LSA to make up for tax-free cash previously given up.
  
  
  Example - David used up 40% of his LTA when he took his DB benefits in 2020. He didn't commute any of the pension for tax-free cash. He had no LTA protection.
  
  Under the standard calculation, his LSA will be reduced by £107,310 (25% of 0.4 x £1,073,100) leaving him with an LSA of £160,965.
  
  Using the alternative calculation, David will be able to make up for all of the previously 'lost' tax-free cash if he has uncrystallised funds of at least £1,073,100 (because the maximum he can take is 25% at each RBCE). However, he takes benefits in October 2024 when his uncrystallised SIPP is valued at £900,000. His tax-free cash will be £225,000.
  
  But this is still £64,035 more than if the standard calculation was used. And if he builds further uncrystallised funds, he can take further tax-free cash - subject to the overall total £268,275.
  To use this alternative calculation, the certificate must be produced before the first RBCE after 5 April 2024.
  
  Clarification is still needed concerning the practicalities for gathering and evidencing the necessary historic information and what obligations providers will have in producing certificates. It appears that they can refuse, but it's unclear in what circumstances this would be allowed. HMRC guidance, expected to be published soon, will hopefully give further detail on the evidence process.

Scheme-specific tax-free cash protection

Some clients who were entitled to more than 25% tax-free cash from their occupational pension scheme (including section 32 buy-out contracts) on 5 April 2006 will still be eligible for scheme specific tax-free cash protection. This could include clients who subsequently 'block transferred' to other types of pension arrangement.

The latest draft sees a change in the formula which will have a beneficial impact for those who have any of the fixed or individual protections.

The current formula is:

• (05/04/06 TFC x £1.8M/£1.5M) + 25% x [retirement fund - (05/04/06 fund x current LTA/£1.5M)]

where 'current LTA' is the standard LTA when benefits are taken. But for those with fixed or individual protection, their protected LTA replaced the current LTA.

The second part of the calculation gives 25% of the difference between the retirement fund and the revalued A-Day fund. As the standard LTA had been reducing, this meant that those without protection could get more tax-free cash than those with protection.

The new formula in the latest Bill simplifies the calculation slightly to:

• (05/04/06 TFC x £1.8M/£1.5M) + 25% x [retirement fund - (05/04/06 fund x 0.7154)]

The 0.7154 figure comes from £1.0731M/£1.5M. With just this simplified formula applying to all, those with fixed or individual should see a higher tax-free cash entitlement than under the current rules. The greatest increases will be for those with 2012 fixed protection.

Pre A-Day benefits

Where benefits were taken before 6 April 2006, but there have been no BCEs before 6 April 2024, they need to be tested to see how much of the LSA they have used up. They continue to be valued in the same way as previously – i.e. 25 x the annual pension in payment at the time of the first relevant benefit crystallisation event (this will be when the first post 5 April 2024 lump sum is to be paid).

Rules for those with LTA protections

As there won't be any LTA testing, the role of the various protection regimes will be solely about increasing the amount of tax-free lump sums.

• Fixed protection or individual protection - The LSA will be set to 25% of the individual's protected LTA.
• Enhanced protection - If they have registered PCLS rights under enhanced protection, their LSA will be limited to what could have been paid out on 5 April 2023. If they don't have registered PCLS rights, their LSA will be set to £375,000 less any lump sums already taken.
• Primary protection - If they have registered PCLS rights, their LSA will be set to their uncrystallised A-Day tax-free cash rights, increased by 20%, less the amounts already taken. If they don't have registered PCLS rights, their LSA will be set to £375,000 less any lump sums already taken.

Small pots, trivial commutation lump sums, winding up lump sums

Under the initial draft of the Bill in July, the tax-free element of trivial commutation lump sums and winding up lump sums counted towards both the LSA and LSDBA, whilst the treatment of the tax-free element of small pots was unclear.

However, with the latest draft of the Bill, this has changed – these are now all ignored when calculating an individual's available LSA and LSDBA. But, to get the tax-free element of these lump sums, the member must have “available thresholds”. We await clarity on what this means in practice.

Summary

Although there are still some areas of uncertainty, the latest Bill does at least allow advisers to start identifying potential winners under the proposed new rules. It's an opportunity to start early in gathering information where a 'transitional tax-free amount certificate' will be required – particularly for clients looking to take benefits early in the new tax year.