The pension lifetime allowance was scrapped last month at the start of the 2024-25 tax year.
Chancellor Jeremy Hunt had previously announced the surprise move in last year’s Spring Budget, bringing cheers from savers with large pension pots and high-paid workers with generous final salary schemes.
But did you know that a trio of pension “lump sum” allowances have been introduced to replace the lifetime allowance?
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
“These new lump sum allowances kick in when you start to take money out of your pension pot,” comments Emma-Lou Montgomery, associate director for personal investing at Fidelity International.
Although the allowances represent more pension rules - and a bewildering number of acronyms - for savers to get their heads round, Montgomery insists that overall the changes are good news.
She notes: “The removal of the lifetime allowance tax charge and the introduction of the new lump sum rules will be welcome news for many pension savers. As with any pension legislation, the rules can look highly confusing, but for someone who hasn’t taken any benefits before 6 April 2024, the legislation is relatively straightforward.”
The three allowances are referred to as “lump sum” allowances, and that’s because consumers can still take as much income as they like from their pension, such as through an annuity.
Tom Selby, director of public policy at the investment platform AJ Bell, explains: “The lifetime allowance was fully removed from the pension tax rules last month, leaving a tax regime where consumers can take as much income as they want from their pension (albeit still subject to income tax) and checks will only be made on lump sums taken.”
We look at the new allowances in detail, and reveal how they work and who they will affect.
1. Lump sum allowance (LSA)
Most pension savers can take a quarter of their pots tax-free when they reach retirement.
The new lump sum allowance will cap your 25% tax-free lump sum at £268,275.
“The number may look arbitrary but it is in fact 25% of the old lifetime allowance of £1,073,100,” notes Montgomery.
The lump sum allowance is triggered when a tax-free element of the pension benefits is taken. For example, a pension commencement lump sum, or an uncrystallised funds pension lump sum (known as UFPLS).
The limit means that those with large pension pots may not be able to take the full 25% tax-free. For example, if your pension grows to £1.5m by the time you want to take money from it, the £268,275 cap on the tax-free cash is the equivalent of just 18% of the nest egg.
Montgomery says: “Your lump sum allowance (LSA) is £268,275 unless you have lifetime allowance protection. However, be aware that if you used some or all of your lifetime allowance before 6 April this year, your LSA will be reduced.”
If you do have lifetime allowance protection, then your allowance increases to a total of £1.5 million under Fixed Protection 14 - made up of a lump sum and death benefit allowance (LSDBA) of £1.5 million and a lump sum allowance (LSA) of £375,000, according to Montgomery.
There’s more information in this article about lifetime allowance protections, like fixed protection.
The new lump sum allowance effectively replaces the old pension commencement lump sum (PCLS) rules.
“What that means in practice is that it will enable people with both a defined benefit scheme and a defined contribution scheme to take a tax-free lump sum from both pensions. Previously, when you claimed a DB scheme pension that used up all your lifetime allowance, you wouldn’t have been left with any allowance to use on a lump sum from your DB pension. Now you can claim from both,” explains Montgomery.
Savers exceeding the LSA will see the excess taxed at their marginal rate of income tax.
2. Lump sum and death benefit allowance (LSDBA)
The next allowance to be aware of is the lump sum and death benefit allowance (LSDBA). This is set at £1,073,100. However, be aware that if you used some or all of your lifetime allowance before 6 April this year, your LSDBA will be reduced.
There are nine circumstances in which the LSDBA is triggered, all when a lump sum payment is made.
These include after taking a serious ill health lump sum or when a lump sum death benefit is paid.
Montgomery explains how it differs from the old rules: “Before 6 April, if you took £100,000 from your pension, triggering the old pension commencement lump sum (PCLS) rules, and then took a further £300,000 from your pension pot you would have used up £400,000 of your lifetime allowance. Under the new rules, you can take the same two lump sums, but only the £100,000 PCLS payment will count towards your LSA and your LSADBA.”
In the case of a serious ill health lump sum, if you’re under 75, haven’t yet taken money from your pension and have fewer than 12 months to live, you can, in theory, withdraw a lump sum up to your remaining LSDBA limit tax-free, according to Montgomery.
She adds that this tends not to happen in many cases though, because for inheritance tax purposes you’re better off leaving as much as you can within your pension, rather than taking it out and having it count as part of your estate.
In the case of defined benefit lump sum death benefit (death in service benefits that are written under pensions legislation) and lump sum death benefits when no money has been taken from the pension yet, LSDBA rules now apply.
Previously, they would have fallen under the old lifetime allowance rules.
Benefits in excess of the LSDBA are liable to income tax at the recipient’s marginal rate.
3. Overseas transfer allowance (OTA)
“The third allowance – an overseas transfer allowance – also set at £1,073,100, measures the value of pension benefits transferred to qualifying recognised overseas pension schemes (QROPS),” comments Selby.
As long as the pension benefits are within the allowance, they can be transferred to a QROPS tax-free.
If they are above the allowance, any excess will still be taxed at 25%.
Note that if you used some or all of your lifetime allowance before 6 April this year, your OTA will be reduced.
