WEALTH MANAGEMENT

UK Pensions – What Has Replaced The Lifetime Allowance?

UK pension planning for US taxpayers can be a very sophisticated and worthwhile strategy when understood and executed correctly. Not only do UK pensions generally allow for tax relief on money contributed into the plan and tax deferred growth on money while in the plan, but UK pensions also provide UK inheritance tax protection which can be an important wealth planning tool for an American in the UK where UK allowances for estate tax purposes drastically differ from the allowances available in the US.

During the Spring Budget Statement in March 2023, chancellor Jeremy Hunt announced a surprising area of reform for UK pensions, namely the intention to abolish the lifetime allowance for TY2425 onwards. Questions regarding how the rules work would in the interim period, and going forward, have taken some time to be answered following the announcement. This has meant undue delays in fully understanding the intricacies of the new rules, and how they apply to pension plans which are close to or have breached the lifetime allowance already – the below provides an overview of where we were prior to last years’ Budget Statement, the rules that applied during TY23-24 (the interim period), and what the new rules look like for TY24-25 and beyond (or until further legislative change is announced!).

What Is/Was The Lifetime Allowance Charge?

The lifetime allowance represented the maximum amount that an individual could accumulate across all their UK pensions before being subject to a penalty at the time of a ‘crystallisation event’ (please see below). The lifetime allowance amount fluctuated over the years, trending downwards, and ultimately was frozen at £1,073,100 since TY20-21.

On commencing to draw from your pension, you were allowed to draw up to 25% of the value of the pension tax-free. This could either be taken as a lumpsum or apportioned across all future withdrawals (making every withdrawal 25% tax-free). The 25% tax-free lump sum was commonly referred to as the ‘pension commencement lump-sum’ and drawing the pension down piecemeal over time is known as ‘flexi-access drawdown’.

This applied to all UK registered pension investors unless specific lifetime allowance protection was held. The falling lifetime allowance over time resulted in more individuals needing to carefully plan for any additional tax charge they may be exposed to during retirement.

Under the historical rules, the lifetime allowance charge imposed on pension savings in excess of the applicable lifetime allowance depended on the timing of distribution of that excess:

• 55% of the value of the excess if taken as a lump sum, or

• 25% of the value of the excess if taken piecemeal as part of flexi-access drawdowns. (Note: with the actual drawdowns then subject to income tax at an individual’s marginal income tax rate). The charge would be payable following a ‘crystallisation event’ - The most common crystallisation events included beginning to draw on the pension, reaching age 75, or passing away before age 75 with no drawings having been made from your pension.

The lifetime allowance remained in force for TY23-24, but the lifetime allowance charge was reduced to zero for the tax year. Instead of any excess above the lifetime allowance being subject to the lifetime allowance charge, any distributions of the excess were merely subject to an income tax charge when distributed.

What Has Replaced The Lifetime Allowance Charge?

As of 6th April 2024, the lifetime allowance framework is replaced by two new allowances:

1. A lump sum and death benefit allowance, and

2. A lump sum allowance.

Without other protections in place, an individual’s lump sum and death benefit allowance is £1,073,100 and their lump sum allowance is £268,275, which represent the lifetime allowance and the 25% pension commencement lump sum amount in place prior to the legislative changes.

The lump sum and death benefit allowance places some limitations around the maximum amount that can be considered tax-free in aggregate during the pension owners’ lifetime and on death. Any lump sum amount in excess of this aggregate amount will be subject to an income tax charge regardless of whether death occurs before age 75 or whether protection is in place.

In addition, an overseas transfer allowance in the amount of £1,073,100 has also been introduced for any overseas transfers of a UK pension to another qualified scheme outside of the UK (which is generally considered a taxable event for US purposes on the entire amount transferred) with any excess balances subject to a 25% overseas transfer charge.

What Is The Impact On Pension Protections?

Where an individual has previously secured primary protection, individual protection or fixed protection, a higher lump sum allowance and lump sum and death benefit allowance will remain applicable based on the thresholds available under the particular protection scheme. In this instance, the total protected amount should remain available as the lump sum and death benefit allowance, and 25% of the protected lifetime allowance should remain available as a lump sum.

Individuals with enhanced protection should note that the treatment going forward has changed. Those with enhanced protection will have a lump sum and death benefit allowance equal to the pension value as of 5th April, 2023, with the lump sum allowance capped at 25% of that applicable value. As a result, future growth on the pension post 5th April, 2023, onwards will no longer remain protected under enhanced protection and would be subject to income tax when excess benefits are received.

Prior to the changes, those with enhanced or fixed protection could lose their protection if any further contributions or benefit accrual took place after the protection took effect. While this rule is still in effect for any new applications for protection made after 15th March, 2023, those with historical enhanced protection and fixed protection have been able to make additional contributions since 5th April, 2023, without losing the protected status.

What Is The Impact Of Changes On Estate Planning Considerations?

Given the overall favourable changes for the accumulation of UK pensions, for a US taxpayer in the UK it is worth looking at both the US and the UK estate tax considerations on a UK pension. UK pensions are held outside of a UK taxable estate, while they are includable in a US taxable estate. As noted earlier, it is generally a useful tool to utilise for UK residents given the large differentials in US and UK estate tax allowances. A UK pensioner has the ability (regardless of age) to nominate a beneficiary of their wish to inherit their pension at death.

There is slightly different treatment on inherited benefits depending on whether the individual dies before or after reaching age 75. The treatment is outlined below:

Death Before Age 75

Where an individual passes away before age 75 without having drawn from the pension, the pension fund would be assessed against the lump sum and death benefit allowance. The full allowance will be available to pass tax-free to the beneficiary and excess taken above this allowance taxed as pension income.

Where an individual had already started to draw from the pension, any remaining lump sum and death benefit allowance would be available to use by the beneficiary, with any excess subject to income tax.

This represents a difference to the prior rules as death wasn’t previously a ‘crystallisation event’ for the purposes of computing lifetime allowance charges where pension funds were already being drawn down prior to age 75. This meant that the entire value of the pension (even in excess of the lifetime allowance) could pass tax-free to beneficiaries previously. This is no longer the case.

To the extent pension benefits are taken via nominee or successor flexi-access drawdown rather than as lump sum death benefits, income distributions will remain tax-free to beneficiaries.

Death At Or After Age 75

If an individual dies prior to drawdown or while in drawdown, the beneficiary can access withdrawals from the pension flexibly over time and there are no restrictions on the amount that can be withdrawn at once. Where a pension fund is not yet in drawdown, the beneficiary is entitled to take the lump sum allowance tax-free with any additional distributions taxed at the beneficiary’s marginal rate of income tax. Where a pension fund was in drawdown with the lump sum allowance utilised, the beneficiary will pay tax on all distributions at their marginal rate of income tax.

Managing the US and UK tax implications of UK pension withdrawals should be a topic of discussion with your US/UK tax adviser and wealth manager to ensure you optimise your drawdown strategy. The flexible drawdown rules and changes to the lifetime allowance regime allow funds to pass on to beneficiaries for their use as they see fit. When embarking on a UK pension distribution strategy it will continue to be important for US taxpayers to consider their US-UK estate tax position and legacy goals accordingly.

Further information please contact

Andrea Solana:

andrea.solana@masecopw.com

The Legal Stuff

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