EIM75420 - The taxation of pension income: lump sums paid to registered scheme members

Overview
Authorised lump sum payments
Identifying the type of payment
Pension commencement lump sum (PCLS)
Uncrystallised funds pension lump sum (UFPLS)
Trivial commutation and small pots lump sums
Serious ill-health lump sum
Stand-alone lump sum
Winding-up lump sum
Other lump sums
Issues with lump sums taxable as pension income

Overview

Registered pension schemes can make lump sum payments to members and to beneficiaries following the death of a member. This page provides guidance on the tax treatment of lump sums paid to members.

EIM75400 provides information on how to find out if a scheme is a registered pension scheme and gives guidance on the tax treatment of pensions paid to a member.

For guidance on the tax treatment of death benefits, see EIM75600 for pensions and EIM75620 for lump sums.

Authorised lump sum payments

Registered pension schemes can pay various types of lump sum to a member. Legislation sets the types of lump sum payments that are classified as authorised payments. Any lump sum payment that is not an authorised payment is taxable as an unauthorised payment. (PTM131000 provides more information about unauthorised payments.)

Legislation sets out the precise circumstances in which particular types of authorised lump sums are paid and, in some cases, the maximum amount.

The tax treatment of the authorised lump sum depends on the type of the lump sum. Some are tax-free, whereas some are wholly or partly taxed as pension income.

Identifying the type of payment

The sections of guidance below give a broad outline of the conditions for paying the various types of authorised lump sums and their tax treatment. Sometimes, on the surface, a payment may look like more than one type of authorised payment. For example, a single payment from a money purchase pension scheme could be:

  • a pension commencement lump sum paid when a member designates funds to provide drawdown pension (but no drawdown pension has been paid yet)
  • an uncrystallised funds pension lump sum
  • an irregular payment of drawdown pension.

The type of payment not only affects how it is taxed under ITEPA 2003 but also how it may be treated under a double taxation agreement.

(This content has been withheld because of exemptions in the Freedom of Information Act 2000)

Pension commencement lump sum (PCLS)

Paragraphs 1 to 3 schedule 29 Finance Act 2004
Section 636A(1) and (2) ITEPA 2003

This is the lump sum that can be taken when a member first starts to receive pension from their pension scheme. That is when the member becomes entitled to a scheme pension or lifetime annuity, or when they designate funds to provide a drawdown pension (EIM75400 provides more information about types of authorised pension). It is normally payable tax-free.

PTM063210 provides guidance on all the conditions that must be satisfied for a payment to be a PCLS and the application of the lifetime allowance.

Uncrystallised funds pension lump sum (UFPLS)

Paragraph 4A schedule 29 Finance Act 2004
Section 636A(1A) to (2) ITEPA 2003

This type of lump sum is payable from 6 April 2015. Broadly, it is when uncrystallised funds (funds not yet used to provide benefits) held under a money purchase arrangement are paid as a lump sum without any connected pension. A member may take as many UFPLS payments as their scheme will allow. PTM063300 provides guidance on all the conditions that must be satisfied for a payment to be an UFPLS.

Normally the tax treatment of an UFPLS is 25% is tax-free and 75% is taxable as pension income (chargeable under section 579A ITEPA 2003).

However, where an UFPLS is paid to a member aged 75 or older and their available lifetime allowance is less than the amount of the lump sum, an amount equal to 25% of the member’s available lifetime allowance is tax-free. The remainder of the lump sum is taxable as pension income.

PTM063300 provides guidance on all the conditions that must be satisfied for a payment to be an UFPLS, and how to calculate the member’s available lifetime allowance for the purposes of determining the tax-free part of the lump sum.

Trivial commutation and small pots lump sums

Where the value of an individual’s remaining rights under a pension scheme is small the member may commute their pension rights into a one-off lump sum payment. The member may commute a pension in payment (crystallised rights) or may commute uncrystallised rights (pension savings that have not yet been used to provide benefits). The tax treatment of the payment depends on whether or not uncrystallised rights were commuted to provide the lump sum payment.

Trivial commutation lump sum

Paragraph 7 schedule 29 Finance Act 2004

A trivial commutation lump sum is where the member commutes all their rights under the pension scheme to a one-off lump sum payment. Since 6 April 2015 a trivial commutation lump sum has been payable only from a defined benefits arrangement or to commute a scheme pension in payment. The member must have reached normal minimum pension age (currently 55 but this will rise to age 57 from 6 April 2028). It is payable only if the member’s total pension savings under all registered pension schemes are worth no more than £30,000. PTM063500 provides details of all the payment conditions for this type of lump sum.

Small pots lump sum

The Registered Pension Schemes (Authorised Payments) Regulations 2009 (SI 2009/1171)

Regulations 6 to 12 allow lump sum payments of no more than £10,000 to be paid to the member in various circumstances. In most cases the payment must extinguish all the member’s remaining rights under the pension scheme. The most common payments are made under regulations 11, 11A or 12. These are often called ‘small pots lump sums’ or ‘small lump sums’. PTM063700 provides guidance on the payment conditions for these lump sums. Regulation 3 provides that these lump sums paid to members are taxable under section 636B ITEPA 2003 as if they were a trivial commutation lump sum.

Tax treatment

Section 636B ITEPA 2003

The tax treatment depends on whether any of the lump sum is paid from uncrystallised rights. Where part or all of the lump sum comes from uncrystallised rights, 25% of the value of the uncrystallised rights is not taxable, whilst the remainder is taxable as pension income. For example, if the whole of a £20,000 trivial commutation lump sum came from uncrystallised rights, £5,000 would be tax-free and £15,000 taxable as pension income. If on the other hand, the £20,000 lump sum was derived from commuting £12,000 crystallised rights and £8,000 uncrystallised rights, £2,000 (25% of the uncrystallised rights) would be tax-free and £18,000 would be taxable pension income.

Serious ill-health lump sum

Paragraph 4 schedule 29 Finance Act 2004
Section 636A(1), (2) and (3A) ITEPA 2003

This lump sum is paid to someone who has not yet taken their benefits. It is paid when a member is so ill that they are not expected to live for more than a year. It is paid in place of the member’s pension payable from the scheme. PTM063400 provides details of all the payment conditions for this type of lump sum.

Payments to someone aged under 75 are not classed as pension income. The lump sum is not subject to Income Tax up to the member’s lifetime allowance. An amount exceeding the member’s lifetime allowance is subject to Income Tax at the member’s marginal rate.

Where, after 15 September 2016, the lump sum is paid to someone aged 75 or older it is pension income chargeable under section 579A ITEPA 2003. Payments made to someone aged 75 or older before 16 September 2016 were subject to a tax charge which was the liability of the pension scheme administrator.

Stand-alone lump sum

Articles 25A to 25D Taxation of Pension Schemes (Transitional Provisions) Order 2006 (SI 2006/572)

This type of lump sum is payable only to certain individuals who were pension scheme members before 6 April 2006 and have a form of ‘lump sum protection’. The conditions for paying the lump sum vary depending on the underlying form of lump sum protection. Guidance can be found at:

  • PTM063130 – for individuals with scheme specific lump sum protection
  • PTM063110 – for individuals with primary protection and lump sum rights greater than £375,000
  • PTM063120 – for individuals with enhanced protection and lump sum rights greater than £375,000.

The lump sum is not subject to Income Tax up to the member’s lifetime allowance. An amount exceeding the member’s lifetime allowance is subject to Income Tax at the member’s marginal rate.

Winding-up lump sum

Paragraph 10 schedule 29 Finance Act 2004
Section 636B ITEPA 2003

This lump sum cannot be more than £18,000. It is paid when an occupational pension scheme is winding-up, in place of providing the member’s promised benefits under another pension scheme or annuity contract. See PTM063600 for details of the payment conditions for this type of lump sum.

It is taxed in the same way as a trivial commutation lump sum.

Other lump sums

Other authorised lump sums payable to a member under a registered pension scheme include:

  • refund of excess contributions lump sum (see PTM045000) – this is not subject to Income Tax (section 636A(1) ITEPA 2003)
  • short service refund lump sum (see PTM045000) – this is subject to a tax charge under section 205 Finance Act 2004 which is the liability of the pension scheme administrator; a member who is otherwise not a taxpayer cannot claim back any tax deducted from the payment as it is not their tax liability
  • commuted equivalent pension benefits (see PTM061200) which, in accordance with Article 37 of the Taxation of Pension Schemes (Transitional Provisions) Order 2006 (SI 2006/572), is taxable in the same way as a trivial commutation lump sum.

Issues with lump sums taxable as pension income

The lump sum is chargeable to tax in the tax year in which it is paid. (The exception to this is where an uncrystallised funds pension lump sum paid during a period of temporary non-residency becomes chargeable on return to the UK – see EIM75450.) The member is liable to pay the tax whether or not they are UK resident.

PAYE must be operated on the lump sum payment. Guidance on how to operate PAYE correctly on these lump sums can be found in CWG2: further guide to PAYE and National Insurance contributions.