The New Rules of Retirement: Understanding the Lump Sum and Death Benefit Allowance (LSDBA)

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In April 2024, the UK pension landscape underwent a significant change with the introduction of the Lump Sum Death Benefit Allowance (LSDBA). This new allowance is part of the broader reforms following the abolition of the Lifetime Allowance (LTA), and it plays a crucial role in how pension benefits are taxed when passed on after death.

For individuals engaged in financial planning, especially those with substantial pension savings, the LSDBA is a key concept to understand and is likely to require specialist financial advice.

What Is the Lump Sum Death Benefit Allowance?

The LSDBA sets a limit on the amount of pension benefits that can be paid out as a tax-free lump sum upon death. As of the 2025/26 tax year, the allowance is set at £1,073,100, mirroring the previous lifetime allowance threshold.

This allowance applies to:

• Tax-free lump sum death benefits from registered pension schemes

• Serious ill-health lump sums paid before death

• Unused pension funds passed on as lump sums

Any amount paid out above this threshold will be subject to income tax at the recipient’s marginal rate.

It is important to note however, that most tax-free lump sum benefits paid during the individual’s lifetime are also deducted from this allowance.

Why Was It Introduced?

The LSDBA was introduced to maintain a cap on tax-advantaged pension savings following the removal of the Lifetime Allowance. While the Lifetime Allowance previously limited the total amount of pension savings that could benefit from tax relief, its removal raised concerns about unlimited tax-free transfers upon death. The LSDBA addresses this by capping the tax-free portion of death benefits.

Real-Life Example: Planning Ahead

Let’s consider the case of Carl, a 68-year-old retired professional living in Warwickshire. Carl has accumulated pension savings of £1.5 million across several schemes. He has not yet accessed his pension pots and is keen to ensure his children benefit from his remaining funds in the most tax-efficient way.

If Carl were to withdraw a tax-free lump sum of £200,000, this would count towards his Lump Sum Allowance (LSA) and his Lump Sum and Death Benefit Allowance (LSDBA). Based on current rules, Carl would have £68,275 lump sum allowance remaining and £873,100 of Lump sum Death Benefit Allowance remaining.

If Carl were to pass away shortly after and his pension funds were paid out as lump sums, only £873,100 would be tax-free. The remaining £426,900 would be taxed at the recipient’s marginal rate, so if his children were basic rate taxpayers, this would be charged at 20%, however if his children were higher rate taxpayer, this would be 40%.

If Carl were to die after 75 years of age, any lump sum would be taxable in the hands of his children, therefore it does not use up any lump sum and death benefit allowance. He dies without fully utilising his remaining allowances.

This scenario highlights the importance of strategic pension withdrawals and considering alternatives such as beneficiary drawdown, which may offer more favourable tax treatment depending on the circumstances.

From 6 April 2027: Pensions to Form Part of an Individual’s Estate

A major shift is also expected from 6th April 2027, when unused pension funds will be included in an individual’s estate for Inheritance Tax (IHT) purposes. This change will significantly affect how pensions are viewed in estate planning and not only how the LSA and LSDBA are applied.

Currently, most pensions sit outside of an individual’s estate for IHT, making them a valuable tool for passing on wealth tax-efficiently. However, from April 2027, this exemption will be removed for certain pension benefits such as:

·       Unused pension funds that have not been accessed before death

·       Defined contribution pensions where funds remain invested

·       Lump sum death benefits paid from these pensions

This means that if an individual dies with unused pension savings, the value of those funds may be added to their estate and subject become subject to IHT at 40%, depending on the total estate value and available nil-rate bands.

Example: Revisiting Carl’s Estate

Returning to Carl’s situation, if he passes away after 6th April 2027 with his £1.5 million in pension savings, this £1.5 million would now be included in his estate for IHT purposes.

As a result, his beneficiaries could face an additional IHT charge on top of paying income tax at their marginal rate if the pension is paid as a lump sum which exceeds the LSDBA. This double taxation risk makes financial planning even more critical.

Some Considerations for Financial Planning

1. Timing of Death: If the pension holder dies before age 75, benefits within the LSDBA are tax-free. After 75, all benefits are taxed at the recipient’s marginal rate, regardless of the remaining LSDBA available.

2. Previous Withdrawals: Specific rules and calculations apply to individuals who may have accessed certain tax-free lump sums prior to 6th April 2024 which may impact their available allowances for the future

3. Type of Benefit: The LSDBA only applies to lump sum payments. If beneficiaries opt for drawdown or annuity, the allowance does not apply, and taxation depends on the age at death.

4. Multiple Schemes: The LSDBA is a cumulative allowance across all pension schemes. It’s essential to track usage across different providers.

5. Nomination Forms: Ensuring up-to-date beneficiary nominations can help direct funds efficiently and avoid delays or unintended tax consequences.

6. Trusts and Death Benefits: Some schemes pay death benefits into trusts, which may have different tax implications. Professional advice is crucial here.

Summary

The Lump Sum Death Benefit Allowance is a pivotal part of the post-LTA pension framework. While it preserves the principle of tax-efficient pension savings, it introduces a new layer of complexity for those planning to pass on their wealth.

Understanding how the LSDBA works and how it interacts with other pension rules is essential for making informed decisions. Taking professional financial advice to help understand these complex rules can make a significant difference in the financial legacy you leave behind.