Lifetime Allowance Update for anyone planning for retirement

Tuesday 21 November, 2023

The scrapping of the lifetime allowance (LTA) charge simplified retirement planning in one stroke.

But although the charge has gone, the LTA framework still hangs over us - at least for the current tax year – which means that benefits will still be tested against the LTA as before.

LTA tax aside, there’s a significant change to the way some death benefits are now taxed. On death before age 75, where the LTA has been exceeded, certain lump sum payments will be subject to income tax on the excess at the beneficiary’s highest marginal rate. However, there’s no income tax charge if the excess is taken as an inherited drawdown.

With the additional rate now starting at £125,140, this could result in many beneficiaries suffering a 45% tax charge on some or all of their benefits if they're unable to take the excess as an inherited drawdown or an annuity.

With the right advice, most clients will be able to avoid this outcome by ensuring that clients are in the right pension and have made the appropriate nominations.

The issue

Before this year’s Spring Budget, if a client died before 75 with a SIPP or personal pension, any uncrystallized pension savings would have been tested against the LTA (if paid within two years of notification of death). Any excess over the LTA would be hit by a 55% tax charge if taken as a lump sum or 25% charge if taken as a pension. There was no further test on savings which had already been crystallised. After payment of any LTA tax, these benefits were free of income tax.

So there was a significant advantage if benefits could be taken as a pension (typically inherited drawdown) rather than as a lump sum.

From the 6 April 2023 the situation changes, but there remains a significant tax advantage if benefits in excess of the LTA can be paid as an inherited drawdown.

With the removal of the LTA tax charge, any death benefits paid as a pension from money purchase pensions will be tax-free (if paid within the two-year deadline).

But any lump sum death benefits paid out that exceed the LTA will be subject to income tax at the beneficiary’s highest marginal rate.

This change can make a big difference to the net benefits received. For every £10,000 of pension funds available on death in excess of the LTA, a higher rate tax paying beneficiary receiving the death benefit as a lump sum would only get £6,000 after income tax (or £5,500 if they are an additional rate taxpayer). Had they been able to nominate their benefits to a drawdown pot, the full £10,000 would be available.

It should be noted that the taxable amount of the lump sum death benefit will also be included in the beneficiary’s income to determine their personal allowance and pensions annual allowance. If high enough, it could wipe out the personal allowance and reduce the annual allowance to just £10,000 for the tax year.

The solution

Clients most at risk of these income tax charges on death are likely to be those with substantial pension savings in older style personal pensions or retirement annuity contracts that don’t offer a drawdown facility. Transferring to a modern SIPP contract that does offer drawdown is the first step for this group.

But that's not all. Once in a SIPP, it’s critical that clients make the appropriate nominations and keep these up to date. To be certain of the option to take death benefits under drawdown, a beneficiary who is not a dependant must be nominated. If not, benefits may have to be paid as a death benefit lump sum and therefore exposed to income tax if they relate to an LTA excess.

Crystallising benefits now

Another solution for some to avoid the possibility of a taxable lump sum death benefit payout on death before age 75 may be to crystallize all their funds now. There will be no LTA charge. But there are still considerations before going ahead.

Those who have already crystallized benefits up to or beyond the LTA have nothing to lose. Leaving benefits uncrystallized will mean an income tax charge if paid out as a lump sum death benefit.

Clients with a significant amount of LTA available have a more difficult decision. Crystallising all their funds now would not result in an LTA charge, but would force them into taking (or giving up) tax-free cash. This is fine if they need the cash and perhaps have a purpose for it, but if it’s not needed immediately and is re-invested, this could inflate the estate, increase the future IHT liability, and expose the new investments to income tax and CGT unless re-investment was possible into an ISA.

Other benefits on death

The change will mainly affect lump sum death benefits from uncrystallised funds, such as personal pensions and SIPPs.

But lump sum death benefits from DB schemes, typically death in service (DIS) lump sums, will also be tested against the LTA. Any benefit paid in excess of the LTA will also be taxable as income at the recipient’s marginal rate, as would any dependants pension payable.

There is little that can be done without leaving the DIS scheme, but this would not be a rational action - better to have a taxable benefit than no benefit at all.

Applying the tax charge

Benefit crystallization events (BCEs) on death will continue to be reported to HMRC by the legal personal representatives of the estate.

Regardless of when within the two-year period the BCEs actually happens, for the purpose of testing they’re deemed to occur simultaneously. HMRC proportionally allocate the available LTA between all the BCEs on death, not just those relating to the payment of lump sum death benefits.

Any income tax due on the excess part of lump sum death benefits will be payable by the beneficiary at their marginal rate.

The future

At present, these rules apply to lump sum death benefits over the LTA. From 2024/25, when the LTA itself is abolished, we don’t yet know if there will a replacement that will still limit tax-free lump sum death benefits on death before age 75. We wait to see the proposals for the new regime.

In the meantime, it is possible for most clients to avoid any income tax charge on death before age 75 by making sure benefits don’t have to be paid as a lump sum death benefit - and that means ensuring that they're in a scheme which allows drawdown, and have made the necessary death benefit nominations.

In summary...

If you want to find out more about planning for your retirement, read our pension planning and retirement advice services information.  Or complete our booking consultation form and an independent financial adviser will contact you for an initial consultation.

 

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