In 2006, the UK government introduced A-day, a reform meant to simplify pensions and increase flexibility. Fast forward to 2024, and we saw the introduction of L-day, which includes significant changes such as the abolition of the Lifetime Allowance (LTA). These adjustments will have a wide-reaching impact, especially for those planning their retirement or dealing with pensions. Let’s dive into what L-day means for your finances and how it could affect your pension strategy.
What Was the Lifetime Allowance (LTA)?
The LTA was the maximum amount you could accumulate in your pension pots without triggering additional tax charges. The LTA had been set at £1,073,100, though it had been as high as £1.8 million in the past. As the LTA decreased, the government offered various protections for people with pension pots exceeding this amount.
Key Changes After L-Day
One of the most notable changes to the LTA is the shift in how excess pension funds are taxed. Previously, if you exceeded the LTA, you would face a tax penalty of 25% for income withdrawals or 55% for lump sum withdrawals. From the 2024/25 tax year, the LTA is no longer applicable. Instead, any excess pension funds will be taxed at your marginal income tax rate, regardless of whether the funds are withdrawn as a lump sum or flexibly.
Example: Mark’s Pension Scenario
Mark enters the 2023/24 tax year with 9.32% of his LTA remaining, equating to £100,000 of unused allowance. Mark’s uncrystallised pension is valued at £200,000. Before L-day, if Mark withdrew the excess £100,000, he would face a 25% tax charge on £25,000 if taken as income or 55% tax on £55,000 if taken as a lump sum. Post L-day, the £100,000 excess is taxed at Mark’s marginal rate, which means the amount withdrawn is subject to ordinary income tax rates rather than the previous flat tax rates for excess pension funds.
The New Lump Sum Allowance (LSA)
Starting from the 2024/25 tax year, the LTA is replaced by a new Lump Sum Allowance (LSA). This allows individuals to take a portion of their pension tax-free, but with a new cap set at £268,275, which is 25% of the soon-to-be-abandoned LTA amount. Those with protections in place will be able to maintain higher allowances.
Payments like pension commencement lump sums or tax-free elements of uncrystallised funds will count toward the LSA. However, some payments, such as winding-up lump sums or small lump sums, will not count towards the LSA.
Important Considerations for LSA
If you have already crystallised 100% of your LTA before 2024, you will no longer have any LSA available. However, in specific circumstances, such as when you took tax-free cash when the LTA was £1 million, you may be eligible for a transitional tax-free certificate, provided you can provide evidence to the pension scheme.
Lump Sum & Death Benefit Allowance (LS&DBA)
Another significant change is the introduction of the Lump Sum & Death Benefit Allowance (LS&DBA). This new allowance limits the tax-free lump sums that can be taken during the pension member’s lifetime and by their nominated beneficiaries upon their death. The cap is set at £1,073,100, or higher if you have protection in place.
For example, if Vicky holds Fixed Protection 2014, her LSA will be £375,000, and her LS&DBA will be £1.5 million. After April 2024, if Vicky takes the maximum LSA of £375,000 and passes away before age 75, her beneficiaries can receive a lump sum from the remaining LS&DBA, up to £1,125,000 tax-free. Any amount above this will be taxed at the beneficiary’s marginal income tax rate.
Flexi-Access Drawdown and Annuitization
One of the more important clarifications in the new pension rules is regarding flexi-access drawdowns and annuities for dependants. After L-day, payments from a deceased pension member’s pension pot, if passed to a dependant or nominee, will remain tax-free for those under 75, as long as it stays within the LS&DBA.
This opens up new opportunities for pension planning, especially for those with larger pots. If the deceased’s pension exceeds the LS&DBA, the excess can be moved into a dependant’s or nominee’s drawdown account, which can potentially be withdrawn tax-free if the individual is under 75. However, if the deceased passes away after 75, the standard tax rules for pensions apply, and the beneficiary’s withdrawals will be taxed at their marginal income tax rate.
Impact on Inheritance Tax and Estate Planning
The changes to pension allowances also have implications for inheritance tax (IHT) planning. For those with large pension pots, not addressing capital gains or pension funds during their lifetime can result in significant tax liabilities for heirs. Instead of passing on assets that have appreciated in value, individuals might end up passing on estates that are subject to both IHT and higher income tax rates.
In the example of Brian, who holds company shares worth £300,000, he has a £150,000 unrealised gain. If he sells or gifts the shares, he would pay 20% tax on the gain, but if he passes away without addressing the gain, his estate could be subject to IHT on the entire value. The heirs could face a 40% IHT bill on the £300,000.
Conclusion
L-day is a significant shift in pension regulations, aimed at making pension management simpler and more predictable. While the abolition of the LTA simplifies things in some ways, it also introduces new complexities with the introduction of the LSA and LS&DBA. These changes present both opportunities and challenges, particularly for individuals with large pension pots or those looking to maximize tax efficiency.
If you are unsure about how these changes might affect your pension strategy, consulting with a financial planner is key to ensuring you’re taking full advantage of the new rules. By staying ahead of legislative changes and planning strategically, you can secure a comfortable financial future while minimizing the tax burden on your estate.
