Unlocking Tax-Free Lump Sums and Protecting Loved Ones
Planning how to use your pension is an important part of preparing for retirement. Recent Government changes mean the rules around lump sums and death benefits have been updated. This guide explains the essentials in clear, straightforward language.
1. What’s New?
Two big changes affect how pensions are taken and passed on:
The Lifetime Allowance has been removed
There is no longer a single cap on your total pension savings.
Two new allowances now apply
These allowances set limits on how much you and your loved ones can receive tax-free.
2. The New Allowances
Lump Sum Allowance (LSA)
- Standard limit: £268,275
- This is the total amount you can usually take tax-free from all your pensions during your lifetime.
- It includes the tax-free cash you take when moving funds into drawdown or when buying an annuity.
- It also covers the tax-free portion of UFPLS withdrawals.
Lump Sum and Death Benefit Allowance (LSDBA)
- Standard limit: £1,073,100
- This covers:
- The tax-free lump sums you take in life (counted under the LSA), and
- Any tax-free lump sum death benefits paid to your beneficiaries if you die before age 75.
How they work together
The LSA is your personal tax-free limit. The LSDBA is the total tax-free limit for you and your beneficiaries combined. Using tax-free cash now reduces what may be paid tax-free on your death.
3. Taking Money from Your Pension
You still have flexibility in how you access your pension.
Tax-Free Cash
- Normally 25% of the amount you choose to access, up to your LSA.
- Anything above the LSA is taxable at your income tax rate.
UFPLS (Uncrystallised Lump Sums)
- If your pension provider allows this, you can take lump sums without entering drawdown.
- 25% of each withdrawal may be tax-free.
- The rest is taxed as income.
Flexi-Access Drawdown
- Your money stays invested and you draw income when needed.
- Only the initial tax-free cash uses your allowance.
- All drawdown income is taxable.
4. What Happens to Your Pension on Death?
Your pension normally stays outside your estate for inheritance tax purposes. However, income tax may apply depending on your age at death and the benefits your loved ones receive.
If you die before age 75
- Lump sums can be paid tax-free if you have enough LSDBA available.
- If the payment is larger than your remaining LSDBA, the extra is taxed as the beneficiary’s income.
- Beneficiary drawdown remains tax-free if the transfer is made within the permitted time limit.
If you die at age 75 or older
- All payments your beneficiaries take—lump sums or drawdown income—are taxed at their income tax rate.
- The LSDBA does not affect tax treatment after age 75.
5. Things to Think About
Tax-free cash now vs. later
Taking tax-free cash reduces the amount your beneficiaries might receive tax-free if you die before 75.
Your own tax position
Withdrawals count as income. Smaller, regular withdrawals can help you stay within your preferred tax band.
Your health and retirement plans
Your expected retirement length may influence whether you draw more income or preserve allowances.
Other assets
Pensions remain one of the most tax-efficient assets for passing on wealth.
6. Simple Examples
Example 1 – Using Some Tax-Free Cash
Sarah crystallises £200,000 of her pension.
- She takes £50,000 tax-free.
- This uses £50,000 of both her LSA and LSDBA. If she dies before 75, any lump sum death benefits reduce her LSDBA further.
Example 2 – Preserving Allowances
Mark has a pension worth £900,000.
- He takes no tax-free cash.
- His full LSA and LSDBA remain available. If he dies before 75, his beneficiaries could receive more of the pot tax-free.
Summary
- The Lifetime Allowance has been removed.
- Two new allowances now apply: the LSA (£268,275) and the LSDBA (£1,073,100).
- These limits affect the tax-free amounts you can take and the tax-free benefits your loved ones may receive.
- Good planning helps you balance income needs with efficient inheritance options.
Appendix: Key Terms Explained
Crystallisation – The point at which you access your pension (e.g., taking tax-free cash or moving funds into drawdown).
Marginal tax rate – The highest rate of income tax you pay based on your total income.
Uncrystallised Funds Pension Lump Sum (UFPLS) – A withdrawal taken without moving money into drawdown.
Beneficiary’s drawdown – A pension pot passed to a beneficiary who can then take income from it.