Pension income options

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The LTA is set by the Treasury and, since it was introduced in 2006, has been set as follows:

2006/07 - £1.5 million

2007/08 - £1.6 million

2008/09 - £1.65 million

2009/10 - £1.75 million

2010/11 - £1.8 million

2011/12 - £1.8 million

2012/13 - £1.5 million

2013/14 - £1.5 million

2014/15 - £1.25 million

2015/16 - £1.25 million

2016/17 - £1.0 million

2017/18 - £1.0 million

2018/19 - £1.03 million

2019/20 - £1.055m

2020/21 - £1,0731m

2021/22 - £1,0731m

2022/23 - £1,0731m

Since 6 April 2018 the LTA has been indexed annually in line with CPI so in 2019/20 it was £1.055m and in 2020/21 it was £1,073,100. It remains at this level to date, having been frozen until 2028 following the Covid-19 pandemic.

However, during the spring budget 2023, the government announced its intention to formally abolish the lifetime allowance with effect from the start of the 2024/25 tax year.

During the 2023/24 tax year, pension schemes are still required to undertaken lifetime allowance tests when benefit are crystallised. However, the rate of the lifetime allowance excess tax charge is zero. In future years, the amount of the tax-free pension commencement lump sum (PCLS) which can be taken by a scheme member will be limited to 25% of the current lifetime allowance. Where the member has lifetime allowance protection, this will be limited to 25% of their protected figure.

Fixed protection

When reducing the LTA to £1.5 million in 2012, the Government recognised that there should be a ‘protection regime’ for those who had already made pension saving decisions based on an LTA £1.8 million. This protection was designed to cover those with savings above £1.5 million or who believed the value of their pension pot would  rise to above that level through investment growth without any further contributions or pension savings and who did not already have primary or enhanced protection.

They were able to apply for ‘fixed protection’, i.e. a personalised LTA of £1.8 million, providing there was no benefit accrual in any registered pension scheme after 5 April 2012. Any excess value above £1.8 million would be subject to a LTA tax charge. This did mean, though, they could take a tax-free PCLS of up to 25% of £1.8 million.

Under defined contribution schemes, benefit accrual occurred if any further relevant contributions were made after 5 April 2012. The only contributions allowed were contributions to provide life cover, which was in place before 6 April 2006.

Under defined benefit schemes it meant that the benefit value (i.e. 20 times the accrued pension plus any separate PCLS) could not increase by more than the relevant percentage in any tax year after 5 April 2012. The relevant percentage was any annual rate of benefit increase specified in the scheme rules on 9 December 2010 or, if no increases are specified, the increase in the Consumer Prices Index (CPI) for the year to the September before the start of the tax year.

Benefit accrual under fixed protection was tested every year, unlike under enhanced protection where it was tested only on transfer or on crystallising benefits.

Sch...

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Flexi-access drawdown

Previously a flexible drawdown plan where the nomination was accepted in a drawdown year starting on or after 27 March 2014

25 × 80% the maximum permitted income that could be paid if the contract was a capped drawdown at the date of the BCE

Flexi-access drawdown

Capped drawdown – converted to flexi-access drawdown on or after 6 April 2015

25 × 80% of the maximum permitted income from a capped drawdown pension that could have been paid when the member’s drawdown pension fund became a flexi-access drawdown fund

Testing against the lifetime allowance

Whenever a BCE takes place after A-Day the value of the new benefits being crystallised is tested against the member’s available LTA and uses up a percentage of that allowance. The remaining percentage is then carried forward for use at the member’s next BCE.

Example

In the tax year 2009/10 when the LTA was £1.75m, Jimmy took a pension commencement lump sum of £218,750 from his personal pension and used the remaining fund of £656,250 to purchase an annuity. The crystallised value of Jimmy’s benefits was £875,000. This used up 50% of Jimmy’s LTA (i.e. £875,000/£1,750,000).

In the tax year 2023/24, when the LTA is £1,073,100, Jimmy started to receive a scheme pension of £12,500 a year from a former employer’s defined benefit scheme. The crystallised value of this pension is £250,000 (i.e. 20 x £12,500). This used up a further 23.29% of Jimmy’s LTA (i.e. £250,000/ £1,073,100). This leaves Jimmy with 26.71% of his LTA available for his next BCE (i.e. 100% - 50% - 23.29%).

Lifetime allowance charge

The LTA charge was a tax charge that applied at any BCE where the crystallised value of the new benefits exceeded the member’s available LTA. The tax charge applied to the excess over the available allowance, known as the chargeable amount. The charge was designed to recoup the tax breaks the member had received on the excess funds over the years they had been sheltered inside the pension tax regime.

Prior to 6 April 2023, the amount of tax charged depended on the form in which the excess benefits were paid:

If the excess was paid as a lump sum, it was taxed at 55%

If the excess was used to provide pension income, it was taxed at 25%. Remember, the pension provided by the remaining 75% was also subject to income tax at the member’s marginal rate of income tax

Example

Rashid crystallises excess benefits valued at £200,000. If he takes this chargeable amount as a lump sum, it will suffer tax of £110,000 (i.e. 55% x £200,000), leaving a lump sum payment of £90,000. If he decides to use the chargeable amount to provide pension income, it will suffer tax of £50,000 (i.e. 25% x £200,000). The pension income provided by the remaining £150,000 will also suffer income tax at his marginal rate of income tax.

Since 6 April 2023, the rate of the charge has been 0%. Technically, it still exists, however, in effect, no tax is paid. Instead, lifetime allowance excess benefits will simply be subject to income tax under PAYE on the recipient. From 6 April 2024, the lifetime allowance excess charge will formally cease to exist.

What tax rates were used to calculate the LTA charge?

Answer : Purchase course for answer

The annual allowance is a limit on the value of ‘pension input amount’ that qualifies for tax relief during each ‘pension input period’.

If the amount of pension input is more than the available annual allowance, an annual allowance charge is paid, charged at the individual’s marginal rate(s) of income tax.

The annual allowance for 2023/24 is £60,000. Prior to the 2023/24 tax year, it had been £40,000 for several years. The increase was announced during the spring budget 2023.

However this is tapered (reduced by £1 for every £2) for those people with ‘threshold income’ over £200,000 and ‘adjusted income’ over £260,000. 

Threshold income is gross taxable income (investment as well as earned):

Less the grossed-up amount of any pension contribution (made by anyone other than their employer), subject to relief at source or net pay

Plus any employment income given up via salary sacrifice via an arrangement set-up on or after 9 July 2015

Less any lump sum death benefits taxed as income

If this is greater than £200,000 then adjusted income must be calculated. (If someone has threshold income of £200,000 or less will not be subject to the taper and there is no need to calculate adjusted income).

Adjusted income is gross taxable income:

Plus any employer contributions

Less any lump sum death benefits taxed as income

If this is greater than £260,000 the annual allowance is tapered, if less or equal to £260,000 no tapering is needed.

As a result of the new pension flexibilities, the money purchase annual allowance (MPAA) was introduced. The MPAA rules work with the annual allowance rules to make sure that the new flexibilities cannot be abused. The MPAA has been £10,000 since April 2023. Previously, it was £10,00...

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This leaves £40,000 to be carried forward from the previous 3 years, starting with the earliest year.

£15,000 is carried forward from 2020/21.

£10,000 is carried forward from 2021/22.

He then carries forward £15,000 from 2022/23 which means there is £5,000 to be used in 2024/2025 or 2025/2026.

The annual allowance charge

The annual allowance charge is a tax charge that applies when an individual’s pension input amount for a tax year exceeds that year’s annual allowance/MPAA. The tax charge is usually levied on the member at their marginal rate of tax. This means that the excess over the annual allowance would be charged at more than one income tax rate if it falls into more than one income tax band. The excess over the annual allowance/MPAA is added to the person’s taxable income (the amount after the personal allowance has been deducted).  The annual allowance charge is collected from the individual via their self-assessment tax return.

Individuals with an annual allowance charge of over £2,000 and whose pension savings exceeded the annual allowance (not just the MPAA) can elect for the scheme administrator to pay all or part of the annual allowance charge on their behalf.  This is known as ‘scheme pays’ and will result in the member's pension benefits being reduced. In defined contribution schemes, the charge will be deducted from the fund and in defined benefit schemes, an adjustment will be made to the accrued benefits.

All contributions paid to UK registered pension scheme count towards the annual allowance, whether they receive tax relief or not. Only contributions paid to non-registered pension schemes (e.g. employer-financed retirement benefits schemes), do not count.

It is possible to carry forward any unused annual allowance to the current tax year from how many of the previous tax years?

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There are two exceptions to the NMPA:

Where deferred or current members of occupational or statutory schemes already had a contractual right to retire at age 50. This right must have existed on 10 December 2003 and must have been genuinely contractual,...

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The new normal minimum pension age will not apply to public service schemes – the police, armed forces, firefighters, etc – they will not have an NMPA that is linked to State pension age.

By how much will the LTA be reduced where a scheme member takes benefits early on the grounds of ill-health?

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Benefits can be taken from a defined contribution scheme in the form of an income and/or as a lump sum. The benefits depend on the size of the fund that has been built up. 

Pension commencement lump sum (PCLS)

A PCLS is usually available except when there is no scope in the scheme rules for any of the proceeds to be paid out as a lump sum (which would be rare) or where the member has used up all of their PCLS allowance.

The maximum PCLS is generally 25% of the fund, subject to a...

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It is an FCA requirement that providers of individual pensions give members the opportunity to choose the insurer which is to provide their lifetime annuity. This is known as taking an open market option (OMO), i.e. buying an annuity from any authorised insurer. This requirement does not extend to occupational schemes but would generally be regarded as good practice.

Members of what types of schemes must be offered an OMO?

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As stated earlier the level of benefits that a member receives at normal retirement age depends on the following factors:

Scheme accrual rate

Pensionable service

Pensionable remuneration

The interaction of these factors will determine the l...

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PCLS = [20 x pre-commutation pension x C]/[20 + (3 x C)] where C is the commutation factor used by the scheme.

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Uncrystallised funds pension lump sum (UFPLS) - these are lump sum payments paid directly out of uncrystallised funds

Guarantee periods: Scheme pension payments may be guaranteed for a period of up to ten years, regardless of the member’s age. For a lifetime annuity, the time limit on a guarantee period was removed from 6 April 2015 and will be at the annuity provider’s discretion. Prior to 6 April 2015, such payments from both scheme pensions and lifetime annuities were taxable for the recipient(s) and could not be commuted. Since 6 April 2015, any income received by a beneficiary under a lifetime annuity guarantee period will now be tax-free if the member died prior to age 75. Income received by a beneficiary from a scheme pension under a guarantee period, and income received by a beneficiary from a lifetime annuity under a guarantee period where the member died on or after age 75, re...

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Such a lump sum is paid without any tax charge. There is also no tax charge on the charity receiving the payment if it is used for charitable purposes.

Members are encouraged to complete an expression of wish form to advise the trustees who they wish benefits to be payable to on death but this is not binding on the trustees, who have full discretion as to who to pay the lump sum to. In most cases, however, the trustees will follow the member’s wishes. If the member does not complete an expression of wish form the trustees must investigate their domestic situation following death to search for dependent persons as defined by the scheme’s rules

What are the death benefits available when a scheme member dies whilst in flexi-access drawdown?

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Where a member’s pension benefits are small they can be commuted for a trivial commutation lump sum or a small pots payment.

Trivial commutation is available where the member is aged at least 55 (or has reached their protected pension age or they meet the ill-health conditions) and on a nominated date the value of their pension rights is not more than £30,000. When the rules changed in April 2015, a trivial commutation payment could only be in respect of ...

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To help simplify retirement rules, the Government reduced the age at which an individual could take a small pot from 60 to 55, with effect from 6 April 2015. It is also possible to take a small pot payment from an earlier age where the member either has a protected pension age or is suffering ill health and takes early retirement.

Explain the conditions that must be met for a member to receive a trivial commutation lump sum.

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Subject to certain transitional reliefs, drawing benefits before normal minimum pension age (55) is only possible on grounds of ill-health.

The Finance Act 2004 defines an ‘ill-health condition’ which must be met for this to occur. The condition is that the scheme administrator has received evidence from a registered medical practitioner that the member is (and will continue to be) incapable of carrying on the member’s occupation because of physical or mental impairment, and the member has in fact ceased to carry on the member’s occupation. Although the rule implies a permanent condition, the legislation has evolved so that a scheme can suspend or reduce payment of an ill-health pension if the member regains their health.

If the member has a life expectancy of less than one year, it is possible to commute their uncrystallised arrangements for a ‘serious ill-health lump sum’. The lump sum will be paid free of tax (subject to a lifetime allowance test) unless the member is age 75 or over, in which case it is taxable as the recipient’s income via PAYE. The member must have some lifetime allowance remaining and each arrangement must...

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Survivor's pensions are usually calculated as a percentage of the member’s pension in payment (e.g. 50%). For calculation purposes, the member’s pension is usually taken as the amount he/she would have received without commuting any of it for a pension commencement lump sum. 

There is no limit on the amount of survivor’s pension that can be drawn if the member dies before their 75 th birthday. If the member dies after age 75 in receipt of a scheme pension, then the survivor’s pension is restricted to 100% of the member’s pension in the year to death, plus 5% of any pension commencement lump sum drawn by the member.

Many schemes allow an allocation option giving retiring members the chance to surrender part of their pensions to increase the potential survivor’s pension.

The Finance Act 2004 defines an ‘ill-health condition’ which must be met for a defined benefit occupational scheme pension to become payable in the event of early retirement due to ill health. State the main elements of this condition that must be adhered to.

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Please note that we will call the person with pension benefits the member and the person claiming part of the member’s benefits on divorce the ex-spouse.

For divorces after December 2000 there are three options.

Offsetting

Offsetting involves ordering the member to pay over a greater share of other non-pension assets than would otherwise have been the case if no pension rights had existed.

Offset has the advantage of leaving pension benefits intact for the pension member, though the obvious disadvantage is that the ex-spouse has no pension provision for retirement. However, offset is still common in the divorce process, with one reason being that it allows a clean break.

Example

Tom and Joyce are divorcing. Their assets are a house worth £400,000, £210,000 in cash and other assets as well as Tom’s pension rights which have been valued at £320,000. Their total assets are therefore £930,000.

If an offset arrangement is agreed, Tom could retain his pension fund plus £145,000 and Joyce should have the house plus £65,000.

Defined benefit schemes

To calculate the gross value of the member’s accrued benefits, the cash equivalent transfer value is used. When establishing the amount of ‘offset’ the following is taken into account:

The ex-spouse will no longer be entitled to any pension and tax free cash once they are in payment

They will not be entitled to a spouse’s pension if the member predeceases them

They will lose any death in service benefits

Defined contribution schemes

The loss to the ex-spouse is worked out by agreeing a percentage or division of the fund taking into account:

Loss of pension benefits

Loss of spouse&...

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With a periodic payment order the ex-spouse is deemed to have received their share of the income from the member; this means the whole income is taxed at the member’s marginal rate.

Earmarking has several major drawbacks:

The member can retire when it suits them and therefore dictate when the ex-spouse will receive any benefit

Benefits stop when the member dies. The ex-spouse could potentially get nothing at all

The ex-spouse cannot define in any effective way how funds are to be allocated and into which types of investment funds. The member could potentially hold all investments in low risk, low-yielding investments

A final salary scheme member could decide to reduce benefits by opting out of the scheme and then starting a new post-divorce pension arrangement

There is a clear incentive to cohabitation in the automatic termination of the court order on remarriage

The whole pension is treated for tax purposes as the member’s and earmarked payments are provided from the net pension received

There is no clean break - something many people desire in this situation

There are advantages however for the member:

No money/assets change hands at the time of divorce

If the ex-spouse remarries the periodic payment order lapses

If the ex-spouse dies before benefits start any periodic payment stops

Member has full control over timing, where funds are invested and decision to transfer

Impact on lifetime allowance

As the member still owns all pension rights, they are valued against their lifetime allowance (even though their pension income will be lower)

The ex-spouse receives a pension that is not valued against their lifetime allowance

What are the two types of earmarking order?

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