Pension companies are currently sending letters to many taxpayers saying that they have used some of their lifetime allowance (LTA). As the LTA has been abolished, why are the letters being sent and why might they matter?
LTA abolished
You probably know that the lifetime allowance (LTA) was a limit on the pension savings you could accumulate for tax breaks to be applied. A special tax of up to 55% applied to pension savings taken if at the time they exceeded the LTA. In 2023 the Chancellor scrapped the LTA charge and announced that the LTA itself would be abolished in April 2024. Instead, sums that would have been liable to the LTA charge are subject to income tax instead.
LTA by another name
In April 2024 two new allowances have been created and apply to pension savings crystallised (pension funds accessed for first time): the lump sum limit (LSL) and the lump sum death benefit limit (LSDBL). These are based on the old LTA and are £268,275 and £1,073,100 respectively. The LSL is the maximum tax-free amount you can take from your pension savings in total and the LSDBL is the amount (after deducting any tax-free lump sums taken during your lifetime) which qualifies for tax breaks when you die. Tip. If you elected for special protection when the LTA was reduced several times you are entitled to a higher LSL and LSDBL.
Trap. If you crystallised any of your pension savings before 6 April 2024 you will have used some of your LTA. This reduces, pound for pound, your LSL and LSDBL. This is why pension companies have recently been writing to individuals who have pension savings with them.
Example 1. Karen is 64. She did not elect for pension special protection and so the normal LTA applied. When she was 59 she crystallised one of her pension funds and in doing so used 70% of her £1,073,100 LTA before 6 April 2024; £751,170. Consequently, her LSL and LSDBL are reduced by £187,792 (£751,170 x 25%) to £80,483 and £885,308 respectively.
Exceeding the LSL
If on or after 6 April 2024 you crystallise any of your pension savings and the tax-free lump sum, added to any tax-free lump sums you’ve taken already, exceeds the LSL, you’ll be liable to income tax on the excess.
Example 2. Karen from our earlier example retires at the end of 2024 and takes her tax-free lump sum from the remainder of her uncrystallised pension savings. This amounts to £130,000, most of which remains in bank accounts to draw on later. The lump sum exceeds her LSL by £39,517 (£130,000-£80,483). Her other income for 2024/25 is £85,000. The £39,517 is added to her other income resulting in extra tax of nearly £21,000. If Karen had delayed taking her lump sum by just a few months, until the next tax year, she could have saved as much as £16,000 income tax.
Tip. Because excess tax-free lump sums are now liable to income tax, usual tax-saving strategies such as delaying income as in our Example 2, can be used.
New lump sum pension limits replace the LTA from 6 April 2024. Any LTA that you used by accessing your pension savings before 6 April 2024 reduces the new limits for tax-free cash you can take from your pension savings in future. The pension company letters are being sent to explain how your pension limits have been reduced by past LTA events.
This article has been reproduced by kind permission of Indicator – FL Memo Ltd. For details of their tax-saving products please visit www.indicator-flm.co.uk or call 01233 653500.