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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 didn't opt for transitional protection may still have their tax-free cash entitlement protected. This is called scheme specific protection.
- 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.
Before 6 April 2012, the tax-free lump sum amount was based on the amount of tax-free lump sum on 5 April 2006 increased in line with the lifetime allowance.
On 6 April 2012 the lifetime allowance reduced from £1.8 million to £1.5 million. But so as not to disadvantage these individuals, it has effectively been maintained at £1.8 million for these calculations.
So, until such time as the lifetime allowance at the time the tax-free lump sum is taken is more than £1.8 million, the amount of the increase will always be 20% of the value of the tax-free lump sum rights on 5 April 2006 (£1.5 million + 20% = £1.8 million).
How is the tax-free lump sum calculated?
Basically, the total tax-free lump sum is:
- the pre-6 April 2006 entitlement to the tax-free lump sum increased by 20% until such time as the lifetime allowance is more than £1.8 million, plus
- 25% of any increase in the value of the plan when benefits are taken over the value of the plan on 6 April 2006. The value of the plan on 6 April 2006 is adjusted proportionately to take into account the change in lifetime allowance since 6 April 2006.
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 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.
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% 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 individual'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'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 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 in April 2023 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 as at 5 April 2006 and the lump sum generated by the post 6 April 2006 growth. In April 2023 the lifetime allowance is £1,073,100, 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 April 2023 when the lifetime allowance is £1,073,100, it's 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 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 cash + 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 lifetime allowance
The individual must have available lifetime allowance when the scheme-specific lump sum is paid. The level of an individual’s lifetime allowance depends on whether or not they have lifetime allowance protection and the form of that protection.
If the individual has:
- no lifetime allowance protection, or
- has enhanced protection but their tax-free lump sum wasn’t protected. This would be the case if at 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 available lifetime allowance is based on the standard lifetime allowance.
For example, if the standard lifetime allowance is £1,073,100, and the individual has already had benefit crystallisation events from another pension scheme using up 60% of the lifetime allowance, their available lifetime allowance is £429,240.
If the individual has another form of lifetime allowance protection, their lifetime allowance is based on the level of their protected lifetime allowance, for example: £1.5 million for fixed protection 2014.
With scheme specific lump sum protection, it's possible to pay a tax-free lump sum of more than an individual’s available lifetime allowance.
If the value of the proposed lump sum is greater than the amount of the individual’s available lifetime 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 lifetime allowance is subject to the lifetime allowance charge.
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.