Money Corner: Spring (Cleaning) Budget: Out with the LTAs and in with the LSAs

Published: 01/07/2024 07:00

When the Chancellor of the Exchequer received his copy of the Spring 2023 edition of the FRJ, I can only imagine how he chuckled when he reached page 19 and found an article titled ‘Pensions on Divorce – Lifetime Allowance [LTA] Tax Issues’. That was a 4-page article – submitted by George Mathieson and me – exploring the ways the LTA interacted with pensions on divorce and highlighting key issues for family law advisers to be wary of. That article was submitted to the editorial board of this publication at the end of 2022, it was reviewed and approved in February 2023, and the Chancellor abolished the LTA in March 2023. By the time of publishing, our article was already out of date.

Whilst the Chancellor’s announcements were welcomed by pension savers, George and I were a little miffed that he did not warn us of his plans. In an attempt to restore our professional integrity, in this article, I will:

  • briefly discuss the LTA as it was;
  • introduce the new allowances that have replaced the LTA; and
  • highlight issues family lawyers may need to consider.

Warning: soon after the Chancellor announced he would abolish the LTA, both the Leader of the Opposition and the Shadow Chancellor stated they would reintroduce the LTA if their party is called to form the next government. It is not clear if those statements were ‘knee-jerk’ responses or fully formed policies, but nonetheless their words hang over us. Much like Schr√∂dinger’s cat, is the LTA there or is it not?

If you are reading this article in a world without the LTA, please read on. If you are reading this article in a world where the LTA has been reintroduced, please stop and go back to last year’s article.

Background

Subject to further legislative change, by the time this article is published, the LTA will have been abolished. The legacy of the LTA, though, lingers within Sch 9 Finance Act 2024 and it is worth briefly outlining the previous regime before we discuss the changes and new allowances.

The LTA was introduced in April 2006 and was a cap on tax-efficient pension savings. Initially, the LTA was set at £1.5m but it was regularly ‘adjusted’, reaching a high of £1.8m, a low of £1m, and a final resting place of a nice, round £1,073,100.

When pension savings were first accessed (and at various other stages referred to as ‘Benefit Crystallisation Events’) the value of the pension benefits was tested against the individual’s remaining LTA. If, on testing, the LTA value of the pension breached the remaining available LTA, the excess amount above the LTA was subject to a penal tax charge.

Different forms of protection were made available both (a) when the LTA was first introduced (enhanced and primary protection), and (b) every time the limit was reduced (fixed and individual protection). A full explanation of these protections is outside the scope of this article; however, it should suffice to say that if an individual made a successful application for protection (and did nothing subsequently to invalidate said protection) they were able to secure an LTA limit that was higher than the prevailing rate.1

For divorce cases involving high-value pensions, the LTA would often add some unhelpful complexities. The more common (at least, of those that found their way to my inbox) were cases where:

(1) The pension credit amount would cause the recipient to breach the LTA.

(a) For instance, H has a defined contribution pension worth £2.5m and he has registered for enhanced protection. In his hands, the full £2.5m is out of scope of the LTA charge.

(b) However, a pension sharing order (PSO) of 50% would transfer £1.25m to W (who we assume does not have any form of protection and is subject to the prevailing LTA limit of £1.073m), thus, c £177,000 is now exposed to the LTA.

(c) Various ‘solutions’ would be considered: (i) W might have been able to elect for some form of protection in her own right, or (ii) it might have been possible to structure the credit as partly qualifying and partly disqualifying, or (iii) the parties could have considered pension sharing up to W’s LTA and offsetting any difference, or (iv) the parties could simply have ‘grossed’ up the pension credit to account for the fact that W had a tax charge to pay (which is inherently destructive of value).

(i) Unfortunately, not all pension sharing reports dealing with high-value pensions are created equal. Some experts chose not to engage in LTA tax matters and either told the instructing solicitors as such (good practice) or left it to the instructing solicitors to deduce from the c 40-page report (bad practice).

(2) The pension debit amount would cause a recalculation of the original member’s individual or primary protection amount, potentially reducing (or losing altogether) their protected limit.

(a) Less common, but if somebody had, say, Individual Protection 2014 with a protected limit of £1.4m, if the adjusted* value of the pension debit caused the current value of their pension funds to fall below £1.4m, that person’s LTA limit would be reduced.

* Adjusted value = pension debit minus 5% (simple) reduction for every complete tax year since 5 April 2014.

(3) The pension credit was deemed to be partly or wholly disqualifying.

(a) This happened when the source of the pension credit was either partly or fully crystallised.

(b) Any pension credit deemed to be paid from crystallised sources is ineligible for tax-free cash, but the recipient could (and should) have applied for an LTA enhancement factor (LAEF) to increase their personal LTA.

(4) In some very rare occasions, some forms of protection might also be lost if the recipient of the pension credit did not have an existing pension arrangement open that was capable of receiving an external credit.

The average pension ‘pot’ in the United Kingdom is worth a little over £110,000 (per ONS data from March 2020), therefore, for the average retiree the LTA was not something they needed to worry about and its abolition was not a cause to celebrate. For family law advisers dealing with significant pensions, though, the abolition ought to have been a moment for collective rejoice. Street parties and so on. Sadly, that was not the case because in his quest for simplification, the Chancellor replaced the LTA with two new allowances, he replaced ‘benefit crystallisation events’ with ‘relevant benefit crystallisation events’, and (as already mentioned) both the Shadow Chancellor and the Leader of the Opposition almost immediately pledged to reverse all changes and reinstate the LTA. What fun!

The new acronyms allowances

Taking the place of the LTA, we now have the Lump Sum Allowance (LSA) and the Lump Sum and Death Benefit Allowance (LSDBA).

The LSA is a limit on the amount of any pension funds that can be taken tax-free. The limit has been set at £268,275, which is the same limit that applied to most people under the LTA regime, i.e. tax-free cash was capped at 25% of the LTA (£1,073,100) which equals £268,275.

The LSDBA is a limit on the amount of any pension funds that can be left on death in the form of a lump sum. The LSDBA has been set at £1,073,100 and is reduced by certain lump sum payments taken during the individual’s lifetime or payable on death. Any lump sum death benefits paid above the LSDBA will be subject to income tax at the recipient’s marginal rate.

Individuals with a higher (protected) LTA should have higher LSAs and LSDBAs. For these people, their LSA should be 25% of the protected LTA and their LSDBA will be equal to the protected LTA.

Time will tell, but I anticipate the LSDBA will affect relatively few people. This is because most modern, defined contribution pension contracts offer the facility for nominated beneficiaries to receive the residual funds in the form of a pension, which is not tested against the LSDBA and is often preferable to receiving the funds as a one-off lump sum. Though, of course, personal advice should be sought on this matter.

Some nuances

Transitional tax-free cash certificates

Individuals who have taken a lower amount of tax-free cash than their remaining LTA would suggest are able to apply for a transitional tax-free cash certificate that should increase their LSA.

This might apply, for example, if someone has a defined benefit pension in payment and they did not take a lump sum from that pension. Previously, putting the defined benefit pension into payment would have been deemed a benefit crystallisation event and used part of the individual’s LTA, meaning the tax-free cash available from other pensions would be capped at 25% of the remaining LTA. Now, with tax-free cash not linked to the remaining LTA, the individual would still have their full allowance available.

The following table shows the impact of this change for an individual who (a) does not have any form of LTA protection and (b) used 50% of their LTA when taking a defined benefit (DB) pension last year.

RegimePre-April 2024Post-April 2024
Reference LTA£1,073,100£1,073,100
LTA used by DB pension50%N/A
Maximum potential lump sum£134,138£268,275

For those who will benefit from a transitional tax-free cash certificate, they must apply for (and furnish their pension provider with) the certificate before initiating a relevant benefit crystallisation event after April 2024. It is worth noting that once a certificate has been provided, it cannot be revoked, even if the tax-free entitlement it confers is lower than the ‘normal’ calculation. Again, this is an area that merits personal advice.

Practical tip: for equality of income calculations, some Pensions on Divorce Experts (PODEs) will equalise incomes only, and some will equalise both incomes and tax-free cash. It may be worth asking the PODE to clarify their approach and comment (if possible) on any disparity between the parties’ available tax-free cash entitlements.

Just as some PODEs chose not to incorporate the LTA within their calculations, I suspect some will choose not to delve into tax-free cash entitlements (which, in fairness, borders on financial advice), so it may be worth asking your friendly, neighbourhood independent financial adviser to cast their eye over any pension sharing reports you receive to confirm whether there is a potential tax-free cash imbalance and what this may mean in practice.

Serious ill-health lump sums (SIHLS)

These are also an area to be mindful of. Previously, SIHLS paid before age 75 were tax-free. Now, only the amount of the SIHLS within the LSDBA is payable tax-free, with any excess being subject to income tax.

In practice, this should affect only very few people, i.e. those under the age of 75, expected to live for less than one year (confirmed by a registered medical professional), and with pensions in excess of their remaining LSDBA.

I expect/hope most family law advisers will never have to contend with SIHLS in the context of pension sharing, but for those few that do, there will be a multitude of financial, tax and practical issues to consider.

Instinctively, you might say ‘let’s organise the PSO to transfer any excess benefits (above the remaining LSDBA) to the ex-spouse, thereby avoiding an excess charge on the SIHLS paid’, but here you may fall into the trap of moving target syndrome and there is a very real risk that the PSO may not be implemented in time. Also, any ‘unspent’ pension funds taken as an SIHLS might be potentially subject to inheritance tax.

Alternatively, the member in ill-health could calculate what they expect to need throughout the remainder of their shortened life expectancy, with a 100% PSO applied over the balance. This may be very tax-efficient but would leave the member in ill-health in a bad state if – counter intuitively – they make a recovery. What would they then live on?

In theory, this risk could be hedged if said member takes their pension as a SIHLS and applies for a purchased life annuity (subject to an annuity provider accepting the application), but for this to work (a) your ducks would need to be in perfect formation and (b) your waivers would need to be impenetrable.

Lifetime allowance enhancement factors (LAEFs)

These were available to individuals who received a disqualifying pension credit. Existing LAEFs continue to apply and will increase the holder’s SIHLS and LSDBA.

Subject to normal deadlines, anyone who became eligible to apply for an LAEF before 6 April 2024 has until 6 April 2025 to apply for the enhancement. After that date, the right to apply (as far as we are currently aware) will be taken away.

All change

If the headlines are to be believed, the Labour party may try to revoke the abolition of the LTA, doing away with the recent changes and reinstating the former regime. This would be immensely complex and most industry experts would advise against it. But it may happen.

If the LTA is reintroduced, there would be potentially significant implications for cases settled on the assumption that the LTA is gone for good. I am not a legal adviser, but it would seem difficult to argue this as a Barder event given the public statements made by senior politicians.

Potentially, the most affected pension sharing cases would be those where (a) an individual receives disqualifying pension credit funds and is not able to apply for an LAEF (who knows if there would be transitional protections introduced), and (b) cases where one party is above pensionable age and the other is below.

Expanding on (b), if a PSO is made where both parties will have pensions above the LTA and it is announced that the LTA will be reinstated, the individual above pensionable age will likely have a window of opportunity to access their pensions under the new regime and avoid an LTA charge, but the member below pensionable age may not have that luxury, and instead have no option but to suffer an LTA charge.

Unfortunately, here, legal advisers are between a rock and a hard place; the risk of the LTA coming back is something that ought to be flagged to potentially affected clients, but practically speaking there may not be much you can do to mitigate that risk.

Summary

  • The abolition of the LTA and introduction of the LSA and LSDBA should not affect low-/middle-money cases.
  • For divorces involving high-value pensions, the next few years will be complicated as we aim to advise our clients based on the current rules, while second-guessing and protecting ourselves and clients from the potential reversal.
  • The pension community continues to ask questions of HMRC. There were several amendments to the draft legislation following the work of technical teams around the country and we expect some amending Regulations to follow. Indeed, one HMRC newsletter issued in April suggested that certain individuals refrain from taking action until further changes are made.

This article only scratches the surface of the potential complexity of the new LSA and LSDBA for divorce cases. In many ways, the new allowances are relatively straightforward, but for divorce cases with a mix of crystallised and uncrystallised funds, and/or cases involving high-value pensions, I suggest treading very carefully. If in any doubt, please seek guidance from a suitably experienced financial adviser versed in both the technical aspects of pensions advice and financial remedy proceedings.

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