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Pension commencement lump sums (tax free cash)

Introduction  

This briefing sets out the rules around pension commencement lump sums, which is more commonly known as tax-free cash.  

Core considerations 

  • Tax free cash is generally limited to 25% of the benefits being crystalised. 
  • Some individuals may have higher (or lower) protected tax-free cash entitlements. 
  • For tax year 2023/24 tax free cash is also limited by the individual’s available lifetime allowance (LTA).
  • Although the entitlement to tax free cash under a defined benefit scheme is broadly the same, the calculation is more complex and may be restricted by the scheme rules. 

Contents

 

When tax free cash can be paid

Tax free cash can be paid once the individual reaches the normal minimum retirement age (currently 55 but increasing to age 57 on 6 April 2028). It can also be paid earlier where a member meets the requirements for an ill-health pension or has an entitlement to a protected low retirement age. 

Tax free cash is technically known as a pension commencement lump sum. This is because it can only be paid in connection with an individual’s entitlement to a “relevant pension” benefit (i.e. a scheme pension, lifetime annuity or drawdown pension) under the same registered pension scheme.   

Although funds have to be designated to drawdown for the associated tax free cash to be paid, there is no requirement to take any drawdown income. Therefore, where an individual only requires tax free cash they can achieve this in a defined contribution scheme via the drawdown option. 

Tax free cash must be paid within a period beginning six months before, and ending 12 months after, a member becomes entitled to a relevant pension. If these conditions are not met then any tax free cash paid becomes an unauthorised payment.  

It is possible to defer tax free cash beyond the member’s 75th birthday from unused funds when taking a relevant pension. Taking tax free cash after age 75 is not a benefit crystallisation event as the benefits would have already been tested at age 75. However, if the member dies after age 75 and before taking their tax free cash, the whole fund is subject to income tax in the hands of the recipient unless it is paid as a charity lump sum death benefit.  

Tax free cash can only be paid provided the member has not used up all their lifetime allowance (LTA) at the time of payment.
 

How tax-free cash is calculated

Where a member does not hold any form of protection (Fixed, Individual, Enhanced, Primary or protected cash) their maximum allowable tax free cash is determined as the lesser of: 

  • 25% of the value of their pension rights, and 
  • 25% of the available standard LTA 

For defined contribution schemes this is generally straightforward.  

For example

Joel has already used up 80% of his LTA by receiving a scheme pension. He also has £300,000 invested in his personal pension and would like to access the tax free cash. The tax free cash is limited to the lesser of 25% of £300,000 = £75,000 25% of the remaining LTA. The remaining LTA is 20% of £1,0731m = £214,620. 25% of this is £53,655 Therefore, Joel’s tax free cash is limited to £53,655. As explained above, tax free cash may be taken after age 75. However, any uncrystallised benefits must be tested against the LTA at age 75. When tax free cash is taken after age 75, the amount of LTA used up by the unused funds at age 75 is ignored.


Tax Free Cash under a Defined benefit scheme

A member of a defined benefit scheme will be provided with a scheme pension. The tax free cash is calculated as 25% of the value of their benefits, although some scheme rules may be more restrictive. Generally, the pension benefits must be commuted or given up to provide the tax free cash. However, some schemes may provide tax free cash as a separate lump sum. 

 

  • Commutating for tax free cash 

When commuting the pension for tax free cash the following formula can be used to determine the maximum tax-free cash: 

Pension x commutation factor x 20 / ((commutation factor x 3) + 20) 

The calculation is also sometimes expressed as: 

Pension x Commutation factor / [1+(0.15 x Commutation factor)] 

Both formula result in the same outcome. In either case the tax-free cash must not exceed 25% of the scheme benefits. 

The residual pension is then calculated as: 

Pension – (max tax-free cash/ commutation factor) 

Where: 

  • pension is the member’s pension benefit before commutation; 
  • commutation factor is that applicable under the scheme concerned. 
     
For example

A member of a final salary scheme has a pension benefit of £40,000 p.a before commutation. The scheme commutation factor is 12:1. Maximum PCLS is £40,000 x 12 x 20 / ((12 x 3) + 20) = £171,428 Residual pension is £25,714 (i.e. £40,000 – [£171,428/12]) To check that the PCLS is 25% of the value of the pension rights: ((£25,714 x 20) + £171,428)/4 = £171,428 (allowing for rounding)
  • Separate Lump Sum  

Some schemes, particularly older public sector schemes provide an automatic right to tax free cash in addition to the pension. This is typically at a level of three times the initial annual pension, or an accrual of 3/80ths of final salary for each year of service. In this case taking the tax free cash entitlement does not reduce the annual pension.

 

For example

A member has 20 years service with a final salary of £40,000. The scheme provides a pension of 1/80th of salary, plus a separate lump sum of 3/80ths of final salary. The benefits would be: Pension of 20/80 x £40,000 = £10,000 Lump sum of (20/80 x 3) x 40,000 = £30,000


However, these schemes may also allow members the option to increase their tax free cash entitlement up to the 25% maximum by giving up some of their annual pension.  

 

Tax free cash and AVCs

The maximum tax-free cash that may be taken is calculated at a scheme, rather than arrangement, level. This will allow individuals more flexibility to amalgamate AVCs and other pension benefits within the same scheme to maximise their tax-free cash. It will also allow, for example, the whole of the tax-free cash to be paid from a separate but linked AVC scheme.  

Although the provisions of the simplified regime permit the above it is necessary to check that the rules of the main occupational scheme will allow the tax-free cash to be taken from the associated in house AVC scheme. Where they do it may prove attractive for a scheme member to take their PCLS, as far as possible, from their AVC benefits particularly if the commutation factor under their DB scheme is unattractive.  

Calculating the crystallised value is more complicated for schemes which include both defined benefit and defined contribution elements. The values will be different depending on whether the tax free cash is provided by commutation of DB pension, from a money purchase pot, or from a mixture of both. 

 

Transitional Protections

Regardless of whether a member holds defined contribution or defined benefits the tax free cash is limited to 25% of the members LTA. There are however some situations where this does not apply.  

  • Fixed or Individual Protection 

Where the member holds a form of Fixed or Individual Protection the standard LTA is replaced with their protected LTA. For example, if they hold Fixed Protection 14 the maximum tax free cash would be limited to the lower of 25% of the value of fund or 25% of the protected LTA of £1.5m. 

Some individuals may be entitled to higher or lower amounts of tax free cash such as in the situations described below. 

 

  • Enhanced & Primary Protection 

For those with Enhanced or Primary protection their tax-free rights will depend on the value and percentage of their tax free cash entitlement at 5 April 2006. Full details and examples are in the HMRC tax manual PTM063100

If a member’s tax-free rights as at 5 April 2006 didn’t exceed £375,000, then they are considered not to have protected lump sum rights. Where this is the case tax free cash is limited to 25% of £1.5m instead of 25% of the current lifetime allowance. 

Individuals with enhanced or primary protection could protect their tax-free cash rights if they exceeded £375,000 at 5 April 2006.  

 

  • Enhanced Protection with protected lump sum rights 

Individuals could register for enhanced protection with lump sum rights if their tax free rights as at 5 April 2006 exceeded £375,000. The tax free rights are expressed as a percentage on the enhanced protection certificate and depending on the total value of their rights, this could be more or less than 25%. This percentage is then available tax free from every pension with the below caveat. 

For members with enhanced protection and lump sum rights, their tax-free cash entitlement is now limited to the maximum that could have been paid on 5 April 2023. For example, if the cash protection was 30% and the fund value was £3m on 5 April 2023, the maximum tax-free cash that could be paid would be £900,000 regardless of how much the fund has grown since.  

Remember you can now contribute to pensions without losing Enhanced Protection, but any additional contributions will not generate any further tax-free cash.  

 

  • Primary Protection with protected lump sum rights 

Individuals could register for primary protection with lump sum rights if their tax-free rights as at 5 April 2006 exceeded £375,000. This protection fixes a specific amount of tax-free cash that can be taken from schemes at different times and in different proportions so long as the total is not exceeded. Members are not limited to only 25% of any pension available as tax free cash.  

 

  • Scheme specific tax-free cash 

Individuals may be entitled to scheme specific tax-free cash protection. Before 6 April 2006, occupational pension schemes could provide more than 25% tax free cash. Under the pre 6 April 2006 rules, tax free cash entitlement was based on the member's salary and service with the employer linked to the scheme. The cash entitlement available at 5 April 2006 is protected and revalued until the benefits are taken.   

To work out the value of a members protected tax free entitlement, first determine the tax-free lump sum rights as at 5 April 2006, and revalue this by 20%. Secondly, calculate any growth in value of the pension since 5 April 2006, and 25% of this is available tax free. 

It is important to remember that this protection does not protect a specific percentage of lump sum rights.

 

  • Standalone lump sums 

Where a member was entitled to take 100% of their pension as a tax free lump sum as at 5 April 2006, then this entitlement is retained. Rather than a pension commencement lump sum (PCLS) a member may take a standalone lump sum.  

A standalone lump sum does not require a relevant pension to commence in order to be an authorised payment.  

From 6 April 2023 the maximum that can be paid tax free is limited to the maximum that could have been paid on 5 April 2023. Any growth in value since 5 April 2023 is now taxable as income against the member.
 

Where tax free cash can be lower than 25%

There are some circumstances where a member will be entitled to less than 25% tax-free cash.  

  • Guaranteed minimum Pension (GMP) 

Plans with GMP may not be able to provide members entitlement to 25% tax free cash.  

It is not possible to pay any tax-free cash from any rights that must provide GMP. The GMP must be put into payment as an income. Where there are other scheme benefits, then the value of the GMP rights is added to the total rights available to determine the members tax-free cash entitlement, which can be taken from the non GMP rights. 

Where GMP has been bought out for example into a S32 bond, if the fund value is insufficient to provide the GMP rights then this would leave no benefits available to pay any tax-free cash. Or, if the fund is sufficient to cover the GMP, then there may only be a small excess available for a member to take tax free.
 

  • Disqualifying pension credit 

Where an individual receives a pension credit following divorce from crystallised funds, no tax-free cash can be paid from this as the original member will have already received the entitlement.  
 

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