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The Government's Spring 2023 Budget announced a number of measures to liberalise pensions taxation and on 18th July it took these measures one step further by announcing the complete abolition of the lifetime limit on career pension savings, as well as introducing new lump sum tax allowances.
The changes are proposed to take effect from April 2024 and will affect individuals' retirement planning and the administration of pension schemes. The below article outlines these changes as well as providing some information on what action pension scheme members will need to take in the face of these changes as well as some more information and background about them.
1. The Main Changes/ Actions Required
On 18 July, HMRC announced latest changes to pension taxation. The Lifetime Allowance, the career limit on individuals' savings in registered pension schemes, is to be completely abolished and new tax allowances are to be introduced on lump sum benefits payable on retirement and death. Action employers and pension scheme trustees will see that there is a lot of detail to the changes that they will need to understand. As a first stage they need to know that the changes take effect in April 2024 and they may affect when members/employees time their retirements. Of course, employers and trustees should not take on responsibility for explaining the changes to individuals - that will be a role for financial advisers, including any retained by the employer as part of its employee benefits package. Publications, such as scheme booklets and other pensions information, will almost certainly need a health warning added, drawing attention to these changes.
2. Background/Abolition of the Lifetime Allowance Tax Charge on 6 April 2023
Following the Spring 2023 Budget, the Government abolished the Lifetime Allowance Tax Charge ("LATC") from 6 April 2023. The LATC previously imposed a tax of 55% on lump sum benefits which took an individual over the Lifetime Allowance, which was a limit applying to the individual's career benefits under all registered pension schemes. The Standard Lifetime Allowance at 5 April 2023 was £1,073,100. Some people (generally higher earners) have had protected higher levels of Lifetime Allowance due to accrued rights built up when the Standard Lifetime Allowance was greater than this. Until 6 April 2023 lump sum tax free cash drawn at retirement was generally limited to 25% of the value of an individual's benefits under a registered pension scheme subject to an overall maximum of 25% of the Lifetime Allowance. Some people have had rights to protected tax free cash of a greater amount than this, due to their accrued rights at 5 April 2006.
3. Complete Removal of the Lifetime Allowance from 6 April 2024
The abolition of the LATC from 6 April 2023 was confirmed by the Finance (No 2) Act 2023, which received Royal Assent on 11 July 2023. Following this, the Government on 18 July 2023 issued a policy paper and draft legislation to go one step further by abolishing the Lifetime Allowance altogether from 6 April 2024. This will mean that scheme administrators will no longer need to check an individual's benefits against the Lifetime Allowance where benefits are drawn after 5 April 2024. The complete abolition of the Lifetime Allowance is also likely to make it more difficult for a future Government to reverse the changes and reimpose the LATC.
4. Freezing of the Limit on Tax Free Cash at Retirement/New Lump Sum Allowance
With the complete removal of the Lifetime Allowance, the limit on tax free cash at retirement is to be permanently frozen at its current level. That level will continue to be 25% of the value of the individual's benefits under a registered pension scheme, but will be subject to a fixed overall monetary limit, the "Lump Sum Allowance", of £268,275 (which is 25% of the Standard Lifetime Allowance at 5 April 2023), or 25% of the individual's personal protected higher level of Lifetime Allowance at 5 April 2023 (or the individual's protected tax free cash limit).
5. New Lump Sum and Death Benefit Allowance
There is to be a new cumulative Lump Sum and Death Benefit Allowance of £1,073,100 (which was the Standard Lifetime Allowance at 5 April 2023)(or higher protected Lifetime Allowance at that date). That new allowance is to apply to the aggregate of the retirement cash sums and lump sum death benefits paid to or in respect of an individual under all registered pension schemes. Such lump sum benefits will be free of income tax within that overall new Lump Sum and Death Benefit Allowance.
Where any retirement cash sum or lump sum death benefit paid to or in respect of an individual under any registered pension scheme takes the individual over the new Lump Sum and Death Benefit Allowance, any excess benefits will be subject to income tax. The recipient of the benefit will be liable to income tax on such excess benefits at the recipient's top marginal rate of income tax. In the case of lump sum death benefits, the beneficiaries of the lump sum death benefit will be liable to such income tax. That income tax liability will replace the liability to pay the LATC, which was at the rate of 55% of the excess over the Lifetime Allowance. The recipient's income tax liability will be at most 45% under current income tax rates and could be much lower than that. Beneficiaries of lump sum death benefits, such as spouses or children, would pay no income tax on them if they are within their income tax allowance (currently of £12,570 per annum) and would pay only basic rate income tax of 20% on a further tranche after that.
6. Unlimited Taxable DB Retirement Cash Sums?
As far as retirement cash sums are concerned, the new income tax charge appears to be designed to replace the existing possibility of Lifetime Allowance Excess Lump Sums, which prior to 6 April 2023 were subject to a LATC of 55%. Currently, the range of potential retirement cash sums from defined benefit (DB) pension schemes is restricted to tax free cash, a Lifetime Allowance Excess Lump Sum, a trivial or small commutation lump sum (subject to limits of £18,000 and £30,000) and a serious ill-health lump sum (which may be paid only where the member has no more than a year to live). This contrasts with the position under DC pension schemes, where a member may draw an unlimited taxable retirement cash sum, known as an Uncrystallised Funds Pension Lump Sum (UFPLS).
Under HMRC's 18 July proposals, however, no limits have been set out as applying to the new taxable DB retirement cash sums, which would exceed the new Lump Sum Allowance. This would give members of DB pension schemes the same rights to an unlimited taxable retirement cash sum as applies under a DC pension scheme (akin to an UFPLS). However, it appears that the absence of restrictions on DB taxable retirement cash sums is unintended by HMRC. We await HMRC's proposals as to what restrictions will apply to taxable DB retirement cash sums.
7. Taxable DC Pension Death Benefits
By way of contrast with DB benefits, considerable flexibility has been granted under existing legislation prior to 6 April 2023 to DC pension schemes. This has included the ability of DC schemes to pay a DC pension on a tax free basis where a member dies under age 75 with uncrystallised DC funds, which are designated as payable to a dependant or nominee of the member within 2 years after the member's death. No income tax currently applies to such DC pensions, though prior to 6 April 2023 such DC pensions have been subject to the Lifetime Allowance and would be subject to the LATC where the Lifetime Allowance was exceeded.
With the abolition of the Lifetime Allowance, HMRC's 18 July proposals would remove the income tax free status of such DC pensions and make the recipient of such a pension liable to income tax on such pension at the recipient's top marginal rate of income tax. That income tax liability would apply without reference to the former Lifetime Allowance or to the new Lump Sum and Death Benefit Allowance (the latter applies only to lump sum benefits) and so would apply regardless of the value of the member's or the dependant's or the nominee's pension rights.
That income tax liability could apply to pension rights of modest value. It remains to be seen whether HMRC will maintain this new restriction on DC pension death benefits. If this restriction is maintained, there would be a tax advantage in paying DC death benefits in lump sum form. Such lump sum DC death benefits would be income tax free within the new Lump Sum and Death Benefit Allowance.
8. Transitional and Member Communications Issues
There are a number of details missing from HMRC's 18 July proposals. It is not clear how benefits which have been drawn prior to 6 April 2024 are to be taken into account towards the new lump sum allowances, particularly where the existence or the extent of a previous retirement cash sum is not known.
There will be member communications issues for pension trustees and scheme administrators, who will need to inform scheme members of their rights on retirement several months before HMRC's 18 July proposals come into force on 6 April 2024. It would be desirable for the uncertainties regarding HMRC's proposals to be resolved before those communications have to be issued to scheme members.
There will be future member communications issues for trustees and scheme administrators as to keeping scheme members informed about how the value of the retirement lump sums which they draw from all their registered pension schemes will compare to the new Lump Sum Allowance.
Jeremy Harris, Partner, Fieldfisher 9 August 2023