Stick or twist? Gambling on pension reform

16 May 2023

The pension lifetime allowance (LTA) is a cap set by the government to limit tax relief on pension savings. If a person’s pension pot exceeds the LTA (£1,073,100 for 2022/23) for a relevant tax year, up to and including 2022/23, in which a crystallisation event takes place or the individual reaches age 75, an LTA tax charge applies on the excess amount. For 2022/23 and earlier years, excess amounts taken as a lump sum are taxable at a rate of 55%, with excess amounts remaining in the pension fund taxed at 25%. Further tax is payable at the individual’s marginal income tax rate on subsequent distributions of pension income, to give, for example, an effective overall tax rate of 55% for a UK higher rate taxpayer. The LTA historically also fixed the pension commencement lump sum (PCLS) – the amount of a pension fund that can be withdrawn tax free.

A welcome change?

Pension professionals have long argued that the LTA was unfair. The amount that can be contributed to a pension fund is already subject to annual contribution limits, and the LTA effectively punishes funds for strong investment growth and, with the LTA frozen in recent years, the impact of inflation. The chancellor’s decision to abolish the LTA from 6 April 2023 was therefore welcomed by the pension industry, and has changed some retirement planning advice. In particular, it caused a rethink about the need to take action to minimise the impact of the 55% tax rate by withdrawing funds at an early date.

Any excitement generated by the LTA abolition was quickly tempered, however, by the announcement by Shadow Chancellor Rachel Reeves that, if elected, the Labour Party would reverse the move. This announcement has magnified uncertainty around the future tax treatment of pension funds, but the reality is that whatever decisions a future government might make, the question of whether to take pension now or later was never straightforward.

RSM does not give regulated pensions advice, but we do advise on the tax implications of actions that individuals may take in respect of pension savings. 

Income tax

With the exception of the PCLS and some death benefits, all pension benefits are taxed as income. The abolition of the LTA charge does not affect the size of the PCLS, which for most pensioners is still calculated as 25% of their plan value, up to a maximum of £268,275. The timing of taking pension income can therefore have a big impact on the amount of tax payable, depending on the individual’s other income in the tax year of receipt. In an extreme case, withdrawing a whole pension fund in 2023/24 when no 55% tax rate applies could result in a large amount of income being taxed at 45% (46% for Scottish taxpayers). Taking smaller withdrawals over a longer period when other income is low could reduce the overall tax bill even if the LTA is reintroduced, because the 55% charge only applies to amounts above the LTA, whereas other amounts are charged to income tax at the person’s marginal income tax rate.

Inheritance tax

The value of UK registered pension funds is generally exempt from inheritance tax. This exemption is lost once funds have been distributed, to the extent that they remain in a person’s estate on death. The effective combined tax rate in this situation can be as much as 67% and, therefore, the best way to reduce the tax liability on pensions is often to defer pension distributions until the funds are actually needed.

Tax planning

At first sight, the withdrawal and possible reinstatement of the LTA charge appears to make 2023/24 the ideal time to cash in a pension fund. The reality is much more complicated, and any such decision needs to take account of all of the implications and personal and family circumstances, and not just to concentrate on the headline 55% tax saving.

For more information, please get in touch with Andrew Robins or your usual RSM contact.