Wealthy pension savers are being cautioned that a new “catch in the small print” of lifetime allowance legislation might put them at danger of paying excessively tax on pension withdrawals.
Pension Savers Urged to Track Tax-Free Withdrawals Amidst Lifetime Allowance Changes
Experts advise that individuals should retain records of tax-free withdrawals from their pension funds, or risk having the taxman guess what they've taken.
The problem stems from the government's decision last year to eliminate the lifetime allowance, which established a £1.073 million cap on what could be accumulated in a pension tax-free.
The move, which takes effect on April 6, 2024, was welcomed by pension owners with larger accounts, but experts said a related decision to limit the amount that may be transferred tax-free from a retirement fund has presented a new difficulty for savers.
The tax-free limit was originally set at 25% of the LTA. However, this has been limited to £268,275 (the new lump sum allowance). It will still be allowed to collect lump amounts in excess of this amount, but anything exceeding the LSA will be considered taxable income.
According to experts, many people are unaware that they must now maintain track of their LSA, which is especially difficult for individuals who took tax-free lump sums under the previous system.
“In the past there was no specific lifetime limit on tax-free cash so there has been no need to keep records as to how much you have taken in total,” stated Alasdair Mayes, partner at LCP, an adviser to pension schemes.
“With the new system coming in, HM Revenue & Customs did not want to ignore the tax-free lump sums which people had already taken, and plan to score those against the newly created lump sum allowance.”
If savers do not have records, HMRC will “estimate” how much has been deducted.
“For many people this will be a reasonable enough assumption, especially for those who only accessed their pension relatively recently. However, for some people this assumption will be far too much.”
HMRC assumes that savers have taken more LSA than they actually have, and they risk losing their tax-free entitlement.
Insights on Navigating Changes in Pension Withdrawals Amidst Tax-Free Limits
Pension provider Abrdn stated in a technical note that “the problem with the default approach is that it assumes that 25 per cent was taken as a tax-free lump sum every time benefits were crystallised prior to April 6, 2024, which may not have been the case.”
It further stated that people in defined benefit plans might not have desired to convert their guaranteed income into a one-time payment. Because guaranteed annuity rates were a possibility in earlier defined contribution plans, participants may have tried to use their whole fund to maximise their income.
“To address this, HMRC allows individuals to apply for a transitional tax-free amount certificate (TTFAC), potentially allowing 25 per cent tax-free cash to be taken with future withdrawals where otherwise there would be no tax-free cash,” Abrdn declared.
Sir Steve Webb, a partner at LCP, acknowledged that the certificate was “well worth” tracking for investors who had received less than the maximum tax-free cash from a prior pension and still had additional pensions to take “which might push them over the new lump sum limit.”
For individuals who have yet to collect their first pension, the process will be rather simple when they do so and withdraw some tax-free income. Their pension scheme or provider will specify in writing how much of their LSA they have used up.
Savers should keep this information handy, since they will be required to tell the provider of any additional pension pots they utilise how much LSA they have used.
“As ever, the golden rule is to keep all of your paperwork,” stated Webb. “The lifetime allowance may have gone away, but the need to keep records of all of your pensions, including ones you’ve taken in the past, has not.”