Small lump sums
There are a number of scenarios, for all scheme types, where it is possible to take a lump sum if a plan value is no more than £10,000.
It is possible to pay small lump sums from an arrangement provided certain criteria are met. This includes such things as payments made as a result of a genuine error but also include some commutation payments, the most important of which are described below.
- There are a number of scenarios, for all scheme types, where it is possible to take a lump sum if a plan value is no more than £10,000.
- A maximum of three non-occupational pensions can be commuted under the small pot rules.
- No limit on the number of occupational pension pensions that can be commuted under the small pot rules.
You will probably be asking yourself 'what does relevant accretion mean?' This typical piece of HMRC-speak refers to unexpected additional benefits that have arisen because of a belated payment received by a scheme or where an individual’s rights are found to be greater than was first thought.
Relevant accretions could be:
- Instances where the value of the individual’s benefits was more than the value the scheme administrator thought they had.
- A benefit the scheme administrator become aware of that they couldn't reasonably have expected to be aware of before.
The conditions that must apply before the additional benefits can be paid out as a lump sum are:
- The payment can only happen if the additional benefits occur after a recognised transfer to a UK registered pension scheme or Qualifying Recognised Overseas Pension Scheme (QROPS) or purchase by the scheme of a scheme pension or lifetime annuity from an insurance company.
- The payment extinguishes the individual’s rights under the scheme (a scheme pension or lifetime annuity bought as above doesn't count as remaining rights).
- The payment mustn't exceed the lesser of the value of the additional benefits and £10,000.
- The payment must be made within six months of additional benefits being paid to the scheme.
Formally known as the de minimis rule for pension schemes, these provisions used to only apply to occupational schemes and public service schemes, but were extended to all registered pension schemes on 6 April 2012.
Occupational schemes & public service schemes
A lump sum that extinguishes an individual's rights under an occupational scheme or public service scheme can be made if:
- The individual is aged at least 55 or is entitled to take their benefits before age 55 because they either have a protected pension age or meet the ill-health condition. There is no maximum age.
- The individual isn't a controlling director or connected to a controlling director.
- The payment doesn't exceed £10,000.
- No recognised transfer had been made from this or any related scheme in the previous three years.
- The payment extinguishes the individual's entitlement to benefits under the scheme, however since 6 April 2015 an annuity in payment may continue provided the individual has not previously taken a stranded pot from the scheme.
- The value of the individual's rights under this and any related scheme doesn't exceed £10,000*.
* If the scheme is a larger pension scheme, there is no need to include rights under a related scheme. A larger pension scheme is one that has at least 50 members and meets various other conditions.
From 6 April 2012 these rules were extended creating a new authorised payment which covers schemes that are not occupational or public service schemes, for example personal pension plans.
The conditions are as follows:
- The payment is made on or after 6 April 2012.
- The payment is made to an individual who is aged at least 55 or is entitled to take their benefits before age 55 because they either have a protected pension age or meet the ill-health condition. There is no maximum age.
- The payment does not exceed £10,000.
- The payment extinguishes the individual's entitlement to benefits under the arrangement, however since 6 April 2015 an annuity in payment may continue provided the individual has not previously taken a stranded pot from the scheme.
- The individual has not previously received more than two payments under these regulations, as only three payments can be made (increased from two payments on 27 March 2014).
The conditions are pretty clear but the second last one needs a little more comment.
'The payment extinguishes the individual's entitlement to benefits under the arrangement'. This is important as the rules apply to arrangements and not to schemes. So, it would be possible to pay out three small pots held in a provider's personal pension scheme as they are separate arrangements.
A payment made under these rules is not actually a trivial commutation lump sum, but it is treated as a trivial payment for taxation purposes. This means that if the payment is made from uncrystallised money, 25% will be tax-free and the rest chargeable to income tax as pension income.
The payment of a small lump sum is not a benefit crystallisation event and as such the funds are not tested against the lifetime allowance.
Lump sum after the payment of a scheme specific lump sum - defined benefit only
The Taxation of Pension Schemes (Transitional Provisions) (Amendment) Order 2009 extended the normal trivial commutation provisions. Since 6 April 2015 this only applies to defined benefit schemes. If tax-free cash which had scheme specific protection is paid, the connected pension can be paid as a lump sum if its value is not more than £10,000.
The conditions which apply are:
- The lump sum must be no more than £10,000.
- The individual is aged at least 55 or is entitled to take their benefits before age 55 because they either have a protected pension age or meet the ill-health condition, but there is no maximum age.
- All or part of the individual's lifetime allowance must be available.
- Except for any pension the individual was entitled to on or before 5 April 2006, the payment must extinguish the individual's rights in the scheme.
- The lump sum must be paid in connection with tax-free cash with scheme specific protection.
- The lump sum must be paid within one month of the tax-free cash being paid to the individual.
- Since the tax-free cash was paid, no contributions have been paid, transfer payment received or made, or an annuity or scheme pension bought by the scheme in respect of the individual.
Valuing the benefits
The following table sets out how the benefits should be valued:
|Type of benefit||Calculation of benefits value|
|Defined benefit scheme (scheme pensions)||Multiply the individual's annual pension before commutation by 20. Where lump sums are provided otherwise than by commutation they are valued using a factor of 1:1 and are added to the above value.|
|Money purchase scheme||The total market value of the funds/assets held, unless a scheme pension is paid, in which case a factor of 20:1 is used.|
|Cash balance plan||The value of the benefits as calculated in line with the scheme rules.|
How is it taxed?
If the lump sum is being paid from uncrystallised funds the individual can receive up to 25% of the lump sum tax-free. The rest is payable at their marginal rate of income tax. This means that if, say they currently pay tax at the 20% basic rate tax, 75% of the lump sum will be subject to this tax. It is important to be aware that taking lump sums from the pension in this way could push them into a higher income tax bracket, which could mean that they need to pay more tax than they originally thought.
If the lump sum is being paid from crystallised funds the entire payment is taxed at their marginal rate of income tax.
The provider or scheme trustee is required to apply tax at the basic rate regardless of the amount of tax the individual is actually liable for. This means that the amount of tax the provider or scheme trustee deducts may be greater or less than the amount which should apply to the individual. If they think that they have paid too much or not enough tax, then they will need to discuss this with HMRC.
If the lump sum is being paid from uncrystallised money and they would have been entitled to more than 25% of their benefits value as tax-free cash at retirement, the amount that they can take tax-free on payment of the lump sum will still only be 25%. The enhanced entitlement to tax-free cash will be lost. However, as detailed in Lump sum after the payment of a scheme specific lump sum section above it may be possible to take the enhanced tax-free cash sum first then pay the remainder as a small lump sum.
How can an individual get their overpaid tax back?
Under PAYE where income tax has been overpaid it will normally be recovered through an adjustment to the tax code for future income payments.
In the case of a pension, HMRC will issue a revised tax code for the provider to apply to future payments.
However, where an individual is taking their pension fund as a lump sum, it is possible that they may not have any ongoing income against which the additional tax can be offset. In this case the individual has two options:
- They can wait until the end of the tax year. A tax refund will be created as a result of the information submitted in their tax return.
- They can reclaim the overpaid tax from HMRC during the tax year using form P53.
Money purchase annual allowance
The payment of a small lump sum is not a benefit crystallisation event nor does it trigger the money purchase annual allowance.
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.