RP case studies: Dealing with a decumulation pension rule quirk

In the latest RP case study, Jessica List looks at a quirk in the rules governing UFPLS and enhanced protection of tax-free cash

In days gone by, people who had enhanced protection but without protected tax-free cash were entitled to the normal tax-free entitlement of a quarter of the standard lifetime allowance.

This principle stood until the lifetime allowance dropped below its original value of £1.5m on 6 April 2014. The rules then shifted to make sure people’s tax-free cash entitlement was still based on a lifetime allowance of £1.5m.

However, there is still a quirk in the rules which people need to be aware of.

The situation

At A-Day (6 April 2006) Luke’s pension funds were worth almost £1.5m. He was no longer contributing to his pensions but did not plan to take benefits in the near future and was optimistic about the potential for growth.

He decided to apply for enhanced protection, understanding that this would mean he did not have to worry about the lifetime allowance which was being introduced with the new rules. His enhanced protection was issued without tax-free cash protection as his lump sum rights at the time were less than £375,000.

Following the introduction of the pension freedoms in 2015, Luke began to think about accessing his pension benefits. He remembered reading that his total tax-free cash entitlement would be up to £375,000 (i.e. 25% of £1.5m), rather than the new, lower lifetime allowance. Luke began to access his pension using uncrystallised funds pension lump sums (UFPLS).

He took the following payments:

June 2015 – £500,000

August 2016 – £200,000

July 2017 – £300,000

25% of each payment was tax-free and the remainder was subject to income tax.

In August 2018, Luke decides to take another UFPLS. By his calculations, he has received £250,000 of his tax-free allowance and should have £125,000 remaining. Therefore, he decides to take a UFPLS of £500,000. He emails his scheme administrator to ask them to start arranging disinvestments in order to make the payment. Nicole receives Luke’s email and immediately spots a problem. She calls Luke to discuss his request.

Nicole confirms that Luke does not have enough lifetime allowance remaining to take a £500,000 UFPLS. Luke thinks that Nicole must have made a mistake and confirms that he has enhanced protection. Nicole goes on to explain that while Luke’s enhanced protection means that he will never have to pay a lifetime allowance charge, strictly speaking, he is still subject to the lifetime allowance and its associated rules. With the UFPLSs he has taken so far, he has used up 90% of his lifetime allowance. He only has 10% remaining, which in the 2018/19 tax year equates to £103,000.

Luke still doesn’t understand what the problem is if he can’t incur a lifetime allowance charge. Nicole explains that the problem is with the UFPLS rules, which state that for individuals who are under age 75, a UFPLS payment must be fully within the person’s remaining lifetime allowance. Therefore, the maximum UFPLS which Luke can withdraw is £103,000, with a tax-free element of £25,750. After that, Luke would need to explore other options for accessing his pension benefits, such as drawdown or purchasing an annuity.

Luke says that he will probably take the £103,000 UFPLS now, and then have a further think about his other withdrawal options. Nicole confirms that this will be possible, but says that while she can’t offer him advice about what he should do, there is another issue which she needs to make him aware of.

If Luke takes a £103,000 UFPLS, he will lose the remaining tax-free cash entitlement. This is because of a rule which states that a person is only eligible to receive tax-free cash if they have at least some lifetime allowance remaining.

Nicole explains that this rule usually makes sense, as someone’s tax-free cash entitlement is normally directly linked to their lifetime allowance entitlement: most people will run out of entitlement to both at the same time.

However, in Luke’s case, his lifetime allowance entitlement (whilst irrelevant from an excess charges perspective) will run out before his tax-free cash entitlement. This means that in order to receive the maximum tax-free cash available, Luke must make sure that the crystallisation which uses up or exceeds his lifetime allowance also uses up his remaining tax-free cash entitlement.

As it isn’t possible to do this using UFPLS because of the rule restricting the overall value of the payment, Luke would need to consider another form of benefits. Nicole reiterates that she cannot offer Luke advice, and recommends that he speaks to an adviser before making his final decision. She offers to send Luke a summary of their conversation in writing so that he has it to refer to later.

The results

After speaking to an adviser, Luke decides that he will use flexi-access drawdown to access his remaining tax-free cash. He can crystallise £500,000 and take £125,000 as tax-free cash, and the remaining £375,000 will go into drawdown.

He can then withdraw this straight away as income and achieve a similar outcome to taking a UFPLS, or opt to leave some or all of it invested within his pension.

As UFPLS will no longer be available, Luke also understands that drawdown will most likely be the best option for him to withdraw his remaining uncrystallised pension benefits in the future.

Jessica List is pension technical manager at Curtis Banks Group