Prior to 6 April 2012, the tax-free lump sum amount was based on the amount of tax-free lump sum at 5 April 2006 increased in line with the lifetime allowance. On the 6 April 2012 the lifetime allowance reduced from £1.8 million to £1.5 million but so as not to disadvantage these members, it has effectively been maintained at £1.8 million for these calculations. So until such time as the lifetime allowance at the time the lump sum is taken is more than £1.8 million, the amount of the increase will always be 20% of the value of the lump sum rights on 5 April 2006 (£1.5 million + 20% = £1.8 million).
Basically the total tax-free lump sum is:
The scheme member must become entitled to all of their pension and lump sum rights (that were not in payment on 5 April 2006) under the scheme on the same day.
The actual formula is the same for money purchase and defined benefits schemes but how it is applied in practice is different.
The different calculations are explained below.
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% or in line with the lifetime allowance if that increases over £1.8 million.
The second part of the formula is used to calculate the member's tax-free lump sum entitlement on their post 6 April 2006 benefits, adjusted for any change in the lifetime allowance from £1.5 million. It is possible that this part of the formula produces a negative figure or zero. The most common reason this could happen is when there have been no contributions paid into the plan post 6 April 2006 and there has been no investment growth. If the figure is negative, use a figure of zero.
Here is 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 in April 2020 when the value of his pension benefits under the scheme had risen to £130,000.
Guy's tax-free lump sum on 6 April 2020 is made up of two elements, the re-valued amount of the tax-free lump sum as at 5 April 2006 and the lump sum generated by the post 6 April 2006 growth. Since 6 April 2020 the lifetime allowance has been £1,073,100, the value of the fund at 6 April 2006 will be 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 will be £60,000 calculated as:
£50,000 x 120% = £60,000
The amount of the post 6 April 2006 increase will be £14,615.00 calculated as:
[£130,000 - (£100,000 x (1,073,100/1,500,000))] x 25% = £14,615.00
Guy can be paid a tax-free lump sum from the scheme of £74,615.00 being £60,000 (the re-valued 5 April 2006 tax-free cash) plus £14,615.00.
The formula is the same for a defined benefit scheme but for defined benefit schemes the tax-free lump sum is not 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 p.a. (uncrystallised value is £10,000 x 20 = £200,000) and tax-free lump sum of £100,000.
Helen's benefits come into payment on 7 April 2020 when the lifetime allowance has increased to £1,073,100, it has been maintained at £1.8 million for the purpose of increasing the protected tax-free lump sum. By this time Helen's pension has increased to £21,000 p.a. The scheme uses a tax-free lump sum commutation factor of 12:1.
The 5 April 2006 rights have now increased as follows:
The protected tax-free cash will have increased to £100,000 x 120% = £120,000
The value of the benefits at 6 April 2006 will have decreased 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 cash + the tax-free lump sum in respect of post 5/4/06 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 a member 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.
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.