Protection of scheme specific tax-free lump sum
Individuals who didn't opt for primary or enhanced protection but had the right to more than 25% of their benefits value on 5 April 2006 as a tax-free lump sum, may still have the higher percentage paid when they take their benefits. This is called scheme specific protection.
Key facts
- Individuals who had a right to more than 25% tax-free lump sum on 6 April 2006 and do not have enhanced or primary protection with registered tax-free lump sum entitlement may still have their tax-free lump sum entitlement protected. This is called scheme specific protection.
- They must have sufficient lump sum allowance and lump sum and death benefit allowance remaining.
- This will mainly affect individuals in occupational schemes (including S32s) but can also include individuals in contract-based schemes, for example personal pension plans, who have block transferred their benefits from an occupational scheme.
Lump sum and lump sum and death benefit allowances
Before 6 April 2024, benefits were tested against the lifetime allowance when a benefit crystallisation event occurred. Benefits in excess of the remaining lifetime allowance were subject to a tax charge.
Since the abolition of the lifetime allowance on 5 April 2024, it is only tax-free lump sums that are tested. They are tested against the new lump sum allowance and the lump sum and death benefit allowance. See our article Lump sum and lump sum death benefit allowances for full details of what is tested against each.
Unlike individuals with lifetime allowance protection, individuals with scheme specific tax-free lump sum entitlement do not have an increased lump sum allowance and lump sum and death benefit allowance. To ensure they are not penalised for getting a tax-free lump sum over 25%, the way the tax-free element is deducted from the new allowances is different for them.
Lump sum allowance
Only 25% of the value of the benefits crystallised is deducted from the lump sum allowance, not the amount of tax-free lump sum paid.
Lump sum and death benefit allowance
The full amount of the tax-free lump sum paid is deducted from the lump sum and death benefit allowance.
How is the tax-free lump sum calculated?
The formula is:
Protected tax-free lump sum on 5 April 2006 x 1.2 + (current fund value – (fund on 5 April 2006 x (member's LSDBA / £1,500,000)/4)
Individuals must become entitled to all of their pension and tax-free lump sum rights (that were not in payment on 5 April 2006) under the scheme on the same day.
The scheme specific tax-free lump sum must be taken in connection with a relevant pension (so a drawdown plan, scheme pension or a lifetime annuity) or in connection with a trivial lump sum. See: HMRC Pensions Tax Manual - PTM063130: Member benefits: lump sums: protection of pre-6 April 2006 lump sum rights: scheme-specific lump sum protection.
The formula is the same for money purchase and defined benefits schemes but how it is applied in practice is different.
Money purchase schemes
This is calculated in 2 parts, the pre-6 April 2006 benefits and the post 6 April 2006 benefits.
The first part of the formula is in respect of the pre-6 April 2006 benefits. This is basically the pre-6 April 2006 tax-free lump sum entitlement increased by 20%
The second part of the formula is used to calculate the individual's tax-free lump sum entitlement on their post 6 April 2006 benefits. This is 25% of the fund growth since 6 April 2006 but with the fund value on 6 April 2006 adjusted. The adjustment factor is lump sum and death benefit allowance/£1,500,000.
It's possible this part of the formula produces a negative figure or zero. The most common reason for this is if no contributions have been paid into the plan post 6 April 2006 and there's been little or no investment growth. If the figure is negative, use a figure of zero.
Here's an example of the calculation:
Guy had a tax-free lump sum of £50,000 in a pension scheme on 5 April 2006. The value of his pension benefits under the scheme was £100,000 on 5 April 2006.
Guy took his tax-free lump sum under the scheme on 5 September 2024 when the value of his pension benefits under the scheme had risen to £150,000.
Guy's tax-free lump sum on 6 April 2023 is made up of two elements, the re-valued amount of the tax-free lump sum on 5 April 2006 and the lump sum generated by the post 6 April 2006 growth. His lump sum and death benefit allowance is £1,073,100, so the value of the fund on 6 April 2006 is adjusted by a factor of £1,073,100/£1,500,000 when calculating how much the fund has grown.
The pre-6 April 2006 lump sum is calculated as:
£50,000 x 120% = £60,000
The amount of the post 6 April 2006 is calculated as:
[£150,000 - (£100,000 x (1,073,100/1,500,000))] x 25% = £19,615.00
Guy can be paid a tax-free lump sum from the scheme of £79,615.00 (the re-valued 5 April 2006 tax-free cash of £60,000 plus £19,615.00).
Defined benefit schemes
The formula is the same for a defined benefit scheme. But for defined benefit schemes the tax-free lump sum isn't immediately obvious.
The easiest way to demonstrate how the calculations work is with an example:
On 5 April 2006 Helen has rights in a defined benefits scheme of £10,000 a year (uncrystallised value is £10,000 x 20 = £200,000) and tax-free lump sum of £100,000.
Helen's benefits came into payment on 29 September 2024. By this time Helen's pension has increased to £21,000 a year. The scheme uses a tax-free lump sum commutation factor of 12:1.
The 5 April 2006 rights are as follows:
The protected tax-free lump sum increases to £100,000 x 120% = £120,000
The value of the benefits at 6 April 2006 decreases to £200,000 x (1,073,100/1,500,000) = £143,080.00.
To calculate the maximum tax-free lump sum Helen's scheme administrator has first to calculate the value of the post 6 April 2006 lump sum. The total benefits crystallised will be:
[Gross pension - (tax-free lump sum/ scheme commutation factor)] x 20 + tax-free lump sum:
= [£21,000 - tax-free lump sum/12] x 20 + tax-free lump sum
= (£21,000 x 20) - (tax-free lump sum/12 x 20) + tax-free lump sum
= £420,000 - (20/12) tax-free lump sum + (12/12) tax-free lump sum
= £420,000 - 8/12 x tax-free lump sum
Total benefits crystallised = £420,000 - 2/3 x tax-free lump sum
The post 5 April 2006 increase in the value of benefits is:
[Total benefits crystallised - benefits at 6 April 2006]
= £420,000 - (2/3 x tax-free lump sum) - £143,080
= £276,920 - (2/3 x tax-free lump sum)
The maximum tax-free lump sum in respect of the post 5 April 2006 benefits is:
= £276,920 - (2/3 x tax-free lump sum) divided by 4.
= £276,920/4 - (2/3 x tax-free lump sum)/4
= £69,230 - 1/6 x tax-free lump sum
The maximum tax-free lump sum = the protected tax-free lump sum + the tax-free lump sum in respect of post 5 April 2006 benefit
Tax-free lump sum = £120,000 + (£69,230 - 1/6 x tax-free lump sum)
Tax-free lump sum = £189,230 - 1/6 tax-free lump sum
1 1/6 tax-free lump sum = £189,230
Tax-free lump sum = £162,197.15
After taking this tax-free lump sum the crystallised value of residual pension will be:
(£21,000 - £162,197.15/12) x 20 = £149,671.42
It's important to note that the commutation factor will determine the maximum amount of tax-free lump sum an individual can have under the tax-free lump sum rules.
Normally a defined benefit scheme will have a commutation factor of around £12 for each £1 of pension given up but this can vary from scheme to scheme. The higher the commutation factor the higher the amount of tax-free lump sum available. This also results in the least amount of pension given up in order to provide the maximum tax-free lump sum.
Scheme-specific tax-free lump sum protection and the lump sum and death benefit allowance
The individual must have available lump sum and death benefit allowance when the scheme-specific lump sum is paid. The level of an individual’s allowance depends on whether or not they have lifetime allowance protection and the form of that protection.
No lifetime allowance protection
If the individual has no lifetime allowance protection, their available lump sum and death benefit allowance is based on the standard lump sum and death benefit allowance.
Enhanced protection but no registered tax-free lump sum
If the individual has enhanced protection and no registered tax-free percentage on their enhanced protection certificate. This would be the case if on 6 April 2006 they had an entitlement to a tax-free lump sum of more than 25% of their benefits value but less than 25% of the lifetime allowance (£375,000). Their lump sum and death benefit allowance is the value of their uncrystallised funds under the arrangement on 5 April 2024.
Other lifetime allowance protections
If the individual has another form of lifetime allowance protection, their lump sum and death benefit allowance is based on the level of their protected lifetime allowance, for example: £1.5 million for fixed protection 2014.
Enhanced with protected tax-free lump sums
If the individual has enhanced protection with a registered tax-free percentage on their enhanced protection certificate, they cannot be paid a scheme specific tax-free lump sum. This is because their maximum tax-free lump sum entitlement is the percentage, shown on their certificate. This percentage is applied to their total benefits value on 5 April 2023 under an arrangement.
For example, the standard lump sum and death benefit is £1,073,100, and the individual has already had relevant benefit crystallisation events from another pension scheme using up £643,860 of their lump sum and death benefit allowance, their available remaining lump sum and death benefit allowance is £429,240.
What if the tax-free lump sum is more than the available lump sum allowance?
With scheme specific lump sum protection, it's possible to pay a tax-free lump sum of more than an individual’s available lump sum allowance and lump sum and death benefit allowance.
If the value of the proposed lump sum is greater than the amount of the individual’s available lump sum and death benefit allowance, the whole tax-free lump sum can still be paid as a pension commencement lump sum.
However, the part of the pension commencement lump sum in excess of the individual’s lump sum and death benefit allowance is subject to income tax at their marginal rate of tax.
There is no tax charge if the scheme specific tax-free amount is in excess of the lump sum allowance but below the individual’s remaining lump sum and death benefit allowance.
Disclaimer
The information provided is based on our current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice. Also it may not reflect the options available under a specific product which may not be as wide as legislations and regulations allow.
All references to taxation are based on our understanding of current taxation law and practice and may be affected by future changes in legislation and the individual circumstances of the investor.