Pensions changes for 2023/24 onwards – how they work

Pensions changes for 2023/24 onwards – how they work

Limits on pension tax relief

For higher earners, the ability to contribute into pensions has, up to now, been curtailed by two restrictions. The Annual Allowance (AA) restricts the amount a person can pay into a pension during a particular year. The Lifetime Allowance (LTA) seeks to cap the size of the fund that accrues during your lifetime. Read more on the key pension tax relief rules here.

These limits are perceived to cause practical problems. Whereas private sector workers caught within the restrictions can control their pension contributions, public sector workers usually cannot, as their employers will continue to contribute based on their earnings. In practice, the only way high earning public sector workers (such as senior NHS clinicians) are able to limit their exposure to AA and LTA charges is by restricting their earnings by choosing to work less, or retire (if only temporarily in the case of some healthcare professionals).

In Budget 2023, the Chancellor announced the abolition of the LTA and the raising of the limits for the AA to “help remove incentives for doctors to work reduced hours or retire early due to pension tax concerns. ”However, the changes from 6 April 2023 apply to all pensions meaning individuals with large pension pots across all sectors of the economy can benefit from them.

Where pension contributions for a tax year exceed the AA, the excess is subject to charge at the persons marginal rate of income tax. The available AA is also tapered by £1 for each £2 adjusted income exceeds a defined limit.

From 6 April 2023, the AA will increase from £40,000 to £60,000. The adjusted income limit will increase from £240,000 to £260,000 and, where tapering applies to reduce the AA for an individual, the minimum tapered AA will be £10,000 (up from £4,000). Therefore, from 6 April 2023, the maximum possible reduction to the AA is £50,000, i.e. anyone with adjusted income of £360,000 or more will have their AA tapered to the £10,000 minimum.

Where a public sector worker is a member of both a closed and an open pension scheme, they will be linked, and the combined pension income will be calculated as if it were a single scheme. This enables the offset of negative real growth in legacy public sector schemes when calculating the AA.

As before, any unused AA can be carried forward for three years and utilised if the AA in a subsequent year is exceeded. For example, if you have unused AAs from any of the past three tax years these can be used in addition to your current year AA limit enabling you to increase your maximum tax-relieved pension contributions for the current year

For 2022/23 and earlier years, the LTA (£1.073m for 2022/23) is the maximum savings an individual can hold in a pension fund without facing penal tax charges when taking pension benefits. On a ‘benefit crystallising event’ (e.g., first accessing pension income or 75th birthday), pension funds are tested and, if their value exceeds the LTA, the excess is subject to a tax charge.

Up to £268,250 (25% of the LTA) can be taken as a tax-free lump sum when benefits are first drawn. The balance of the LTA can be used to acquire an annuity, or be drawn down as needed, in both cases subject to PAYE.

For any excess pension fund above the LTA, for 2022/23 and earlier years, there is a LTA charge when taking the funds. The amount of charge will depend on how the excess amount is accessed. When the excess is taken as a lump sum, tax is charged at a rate of 55%. Where the excess remains in the pension fund an automatic 25% charge applies - the lower amount reflects the fact that future withdrawal of those funds will be subject to PAYE.

An LTA charge can also arise when benefits are not accessed, e.g., on 75th birthday or death before 75th birthday – usually a 25% LTA charge on the basis that no lump sum is taken.

From 6 April 2023 onwards, the LTA charge will no longer apply in terms of calculating tax due on any excess pension savings: initial legislation will remove the LTA charge, with the complete abolition following in a later Finance Bill.

Importantly, the existing LTA limit of £1.073m will continue to apply for the purpose of capping the 25% tax-free lump sum. This means that for most people the maximum tax-free lump sum they could accrue will remain £268,275. However, where a pension protection is held, the maximum lump sum is 25% of the protected amount.

From 6 April 2023 onwards, instead of the LTA charge, if the excess pension savings are taken out in the form of a lump sum, they will simply be subject to income tax at the individual’s marginal rate (ie up to 45%). So, the effect of the change for high earners taking the excess as a lump sum is likely to be to exchange a 55% tax charge for one of 45% - an effective reduction of 10%: of course, those with a lower annual income may see a larger effective benefit.

The real tax reduction arising from the abolition of the LTA is for those who do not choose to withdraw the excess immediately as there will be no 25% charge. Drawing down on larger funds will be subject to income tax, but that was previously the case too.

There have been no changes to the Inheritance tax treatment of pensions funds. Therefore, to the extent that pension funds have not been withdrawn by the time the individual dies, the full value should pass to individuals nominated beneficiaries without an immediate Inheritance tax charge. If the individual dies before age 75, there will be no tax charges at all (income tax or inheritance tax) on the beneficiaries drawing the funds: where the individual dies after age 75, the beneficiaries will be liable to income tax at their marginal rate when the funds are drawn out.

Individuals who have protected their LTA in past years may have been restricted from adding new funds to their pot as a condition of that protection. From 6 April 2023, individuals who held protection for their pension before 15 March 2023 will be able to accrue new pension benefits, join new arrangements or transfer their savings without losing their entitlement to their higher protected LTA amount for the purposes of the 25% tax free lump sum.

When a person first accesses a pension of any kind to draw income, their available annual allowance for all subsequent years, for the purpose of defined contribution schemes, is automatically tapered to the MPAA, regardless of their income level. The MPAA will be increased from £4,000 to £10,000. Therefore, individuals who have already started to take pension income but have resumed or continued work, can again top up their pension funds from 2023/24 onwards.

Planning ahead

The proposed changes will be welcomed by higher earners looking to contribute more into their pensions and individuals who already have pension funds valued above the £1.073m LTA – particularly those who do not have a higher protected LTA. We would expect the new rules may lead to changes in widely used pension withdrawal strategies recommended by Independent Financial Advisers.

It is important to acknowledge that the Labour party have stated they will reinstate the existing LTA charge rules if they come into power. We may also see further technical changes when the LTA is formally abolished (expected in 2024). Therefore, there may only be a limited window of time for individuals to benefit from these new rules.

Any individual with a large pension pot should now seek expert advice on their options and the related tax implications for their family finances while the new rules remain in existence.