Scheme specific tax-free cash protection and the order of planning

When the lifetime allowance (LTA) was abolished in April 2024, the formula for revaluing any protected tax-free cash was updated to fit in the with the new lump sum allowance (LSA) and lump sum and death benefit allowance (LSDBA) rules. However, the revaluation provides the same entitlement as it would have done under the old regime. 

 

Revised formula

 

Tax-free cash entitlement at A-day x 1.2

+

25% of (Fund value now – fund value at A-day x LSDBA/1.5m)

 

Example 1

 

With no LTA protection

 

Cash entitlement at A-day    £50,000

Fund value at A-day                   £100,000

Fund value now                            £200,000

 

Revaluation

 

£50,000 x 1.2 = £60,000

+

25% of (£200,000 – £100,000 x £1.0731m/£1.5m) = £32,115

 

Total tax-free cash £92,115.  Expressed as a percentage = 46%.

 

With LTA protection

 

If the individual has Fixed Protection of £1.5m for example, part two of the calculation becomes £25,000.

 

25% of (£200,000 - £100,000 x £1.5m/£1.5m) = £25,000.

 

The total is therefore £85,000, or 42.5% expressed as the current percentage.

 

Note that any form of LTA protection will mean a lower revalued protected amount than for those without protection.

 

In these examples, there is a clear and substantial benefit of the scheme specific tax-free cash protection, with both scenarios producing far greater levels of tax-free cash entitlement than the £50,000 entitlement that would apply without it.

 

In other cases, the protected amount can appear to be minimal, say, for example, the cash entitlement at A-day was only 26%.  

 

Example 2

 

Cash entitlement at A-day    £26,000

Fund value at A-day                   £100,000

Fund Value now                           £500,000

 

Revaluation

£26,000 x 1.2 = £31,200

+

25% of (£500,000 – £100,000 x £1.0731m/£1.5m) = £107,115

 

Total £138,315. This is now 27.7% expressed as a percentage.  

 

Originally, the protection was only worth £1,000 but the revaluation method has increased this to £13,315 and, so, even a small amount of A-day protection can produce worthwhile benefits now.

 

As well as providing a higher percentage of cash from the policy, when benefits are taken, the protection can offer two other advantages for those with substantial total pension benefits as outlined below. 

 

Taking benefits with protected tax-free cash

 

When protected tax-free cash is taken, the first advantage is that, regardless of the level of protected tax-free cash, the LSA reduces by 25% of the value of the benefits crystallised. The LSDBA reduces by the full value of tax-free cash.

 

In the first example above, the individual has a tax-free cash entitlement of £92,115 and a fund value of £200,000. When they take their cash, the LSA amount used is just £50,000. The LSDBA used is £92,115. 

 

The second, and potentially more valuable advantage for those with substantial pension funds, is that, where the protection applies, the individual only needs sufficient LSDBA and not LSA for the cash to be paid free of tax. This means the order of planning is important.

 

Order of planning

 

Returning to our first example, and assuming the individual has £1m of additional uncrystallised pension funds.

 

Policy A – fund value £200,000, tax-free cash entitlement £92,115.

Policy B - fund value £1m, tax-free cash entitlement £250,000.

 

Policy A taken first. Tax-free cash received £92,115. LSA used is £50,000. LSDBA used is £92,115.

 

LSA remaining £218,275; LSDBA remaining £980,985.

 

Policy B - £218,275 LSA available and be paid as tax-free cash. £781,725 of the funds are taxable.

 

Total tax-free cash £310,390. The protection ensures the individual achieves more than the standard LSA of £268,275.

 

Changing the order

 

Take policy B first. 

 

Policy B. £250,000 paid as tax-free cash. £750,000 taxable. LSA/LSDBA used £250,000. LSA remaining £18,275. LSDBA remaining £823,100.

 

Policy A.

 

As this has protected tax-free cash its only necessary to check against the LSDBA and not the LSA.

 

Therefore, whilst the remaining LSA is only £18,275, the full £92,115 can be paid as tax-free cash.

 

By changing the order, the total tax-free cash available becomes £342,115 instead of £310,390.

 

The example shows that the protection can provide significantly more tax-free cash entitlement in the right circumstances and where the benefits are taken in the right order. 

 

Where the individual holds total funds in excess of the LSDBA, it will usually be preferable to take any policies with protected tax-free cash last assuming there is sufficient LSDBA to cover the cash entitlement.

 

Limitations

 

To ensure any protected tax-free cash is not lost there are certain conditions that must be met.

 

Firstly, all of the benefits within the protected scheme must be taken at the same time. This can be achieved by taking all of the cash and moving the remaining funds into drawdown. However, often, the cash entitlement is held in older style policies and sometimes these do not offer a drawdown option. This may mean that the individual must buy an annuity to secure the additional cash entitlement or alternatively transfer out if possible. 

 

This brings us to the second important restriction. The protected tax-free cash entitlement is only maintained on transfer where it is done as part of a ‘block transfer’. This is where two or more members of the same scheme transfer to another scheme at the same time. In addition, the individual cannot have been a member of the new scheme for more than 12 months prior to the transfer.

 

A transfer of a buy-out policy (Section 32) to another buy-out policy will also ensure the any protected cash entitlement is maintained.

 

In summary

 

Protected tax-free cash can be a valuable benefit. As with all tax-free cash, the benefit is greater for those who would otherwise pay higher or additional rate taxes if it was instead taken as income. Where individuals hold plans with protection, care needs to be taken in terms of the timing of the benefits and assessing the value of the protection versus any restrictions it may put upon how and when the remaining benefit must be taken.