Pension savers warned of new tax-free lump sum cap

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Wealthy savers are warned that a new “catch in the small print” of reforms to the lifetime allowance may put them at risk of overpaying tax on pension withdrawals.

The warning comes from experts who are urging individuals to ensure they keep records of tax-free withdrawals from their pension pots or face the taxman guessing what they’ve taken.

The issue centres on the government’s decision last year to scrap the lifetime allowance, which set a £1.073mn limit on what could be accumulated in a pension tax free.

Coming into effect on April 6 2024, the move was welcomed by pension holders with larger funds, but experts said a corresponding decision to cap the amount that can be taken tax free from a retirement fund had introduced a new complication for savers.

The tax-free limit was previously 25 per cent of the LTA. But this has subsequently been capped at £268,275 (the new lump sum allowance). It will still be possible to take lump sums above this amount, but anything above the allowance (LSA) will be treated as taxable income.

Experts say many savers are unaware the onus is now on them to keep track of their LSA — a particular headache for those who have already taken tax-free lump sums under the old 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,” said 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 don’t have records, HMRC will “estimate” how much has been taken.

“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.”

Savers assumed by HMRC to have taken more of their LSA than they actually have risk losing out on their tax-free entitlement.

“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,” said Abrdn, a pension provider, in a technical note.

It added that those in defined benefit schemes may not have wanted to turn their guaranteed income into a lump sum. Older defined contribution schemes could have had guaranteed annuity rates, so members might have aimed to use all of their fund to secure the greatest 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 said.

Sir Steve Webb, a partner at LCP, added that the certificate was “well worth” exploring for savers who had taken less than the maximum tax-free cash from a previous pension and have further pensions still to take “which might push them over the new lump sum limit.”

For those yet to take their first pension, the system will be relatively simple when they take a pension and withdraw some tax-free cash. Their pension scheme or provider will set out in writing how much of their LSA they have used up. 

Savers need to keep hold of this information as they will have to tell the provider of any other pension pots they take how much LSA they have used up.

“As ever, the golden rule is to keep all of your paperwork,” said 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.”