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Pensions Tax Manual

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Member benefits: essential principles: lump sums

 

Glossary PTM000001
   

 

Types of authorised lump sum benefits that may be paid to a member
Lump sums taxable as pension income
Operating PAYE on the lump sum payment
What happens when the limits on authorised lump sums are exceeded
Authorised lump sum payments and the lifetime allowance
Member’s entitlement to an authorised lump sum payment
Commuted equivalent pension benefits (EPBs)

Types of authorised lump sum benefits that may be paid to a member

Section 164(1)(b) & (f), section 166 and Schedule 29 Finance Act 2004

Regulation 2(a) The Registered Pension Schemes (Authorised Payments) Regulations 2006 - SI 2006/209

Various types of authorised lump sum payment are specifically defined by legislation. This legislation sets out in the ‘lump sum rules’ the precise circumstances in which particular lump sums may be paid and, in some cases, the maximum amount. These types of lump sum are collectively referred to in the legislation as ‘authorised lump sums’.

Any lump sum paid by a registered pension scheme that meets the definition of one of these types of authorised lump sum is an authorised member payment. Any lump sum payment that does not fall within one of these definitions is an unauthorised member payment and is taxed accordingly - see PTM130000.

The various types of lump sum that are authorised member payments are:

  • a pension commencement lump sum, see PTM063200 for details
  • an uncrystallised funds pension lump sum - from a money purchase arrangement, see PTM063300
  • a stand-alone lump sum, see PTM063130
  • a serious ill-health lump sum, see PTM063400
  • a refund of excess contributions lump sum (this lump sum is a return of contributions paid to the scheme rather than a “benefit” under the scheme, so is covered under Chapter 4 of this guidance - see PTM045000 for more detail)
  • a trivial commutation lump sum (for commutation periods starting on or after 6 April 2015, this type of lump sum can only be paid from a limited number of sources), see PTM063500
  • a lifetime allowance excess lump sum, see PTM084000
  • a short service refund lump sum - from an occupational pension scheme only (this lump sum is a return of contributions paid to the scheme rather than a “benefit” under the scheme, so is covered under Chapter 4 of this guidance - see PTM045000 for more detail), and
  • a winding up lump sum - from an occupational pension scheme only, see PTM063600.

In addition to the authorised payments under the ‘lump sum rule’, certain other lump sum payments specified in regulations are also authorised payments when they are made by registered pension schemes.

This includes the payment of certain lump sums representing commuted equivalent pension benefits known as an equivalent pension benefits lump sum. Equivalent pension benefits are contracted-out rights earned between 1961 and 1975. This type of lump sum is authorised for tax purposes under Article 37 of The Taxation of Pension Schemes (Transitional Provisions) Order 2006 (SI 2006/572) and regulation 2 of The Registered Pension Schemes (Authorised Payments) Regulations 2006 (SI 2006/209). See guidance at the bottom of this page for more details.

PTM063700 provides details of other types of authorised lump sum payments that are authorised by regulations (including small pot lump sums).

Any lump sum payment made to a member that does not fall within the definitions of the lump sum payments above, is not an authorised lump sum. It is therefore an unauthorised member payment.

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Lump sums taxable as pension income

Sections 636A, 636B and 683 Income Tax (Earnings and Pensions) Act 2003

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

Article 37 of The Taxation of Pensions (Transitional Provisions) Order 2006 - SI 2006/572

The following lump sums are taxable as pension income in the tax year in which the payment is made:

  • an uncrystallised funds pension lump sum (see PTM063300)
  • commuted equivalent pension benefits (see bottom of this page)
  • a trivial commutation lump sum (see PTM063500)
  • a serious ill-health lump sum paid on or after 16 September 2016 and where the member had already reached age 75 (see PTM063400)
  • a winding-up lump sum (see PTM063600), or
  • certain other small lump sum payments (PTM063700)

The person liable to tax is the scheme member receiving the payment.

For an uncrystallised funds pension lump sum, providing the member has sufficient available lifetime allowance, 25 per cent of the lump sum is free of income tax, and the remaining 75 per cent is taxed as pension income (see PTM063300 for more detailed guidance).

For the other types of lump sum listed above, the amount of tax due depends on whether or not the member has drawn or was entitled to any benefits from the registered pension scheme before the lump sum was paid.

If the member has not taken or was not entitled to any benefits from the scheme before payment of the lump sum, the taxable amount is 75 per cent of the amount of the lump sum payment.

If before the lump sum is paid the member has taken benefits, or was entitled to the payment of benefits, from the scheme but also had other uncrystallised rights in the scheme, the taxable amount is the amount of the lump sum paid less 25 per cent of the value of the uncrystallised benefit rights. The uncrystallised rights must be determined in accordance with section 212 Finance Act 2004. PTM134500 explains how uncrystallised rights are valued for the purposes of section 212 Finance Act 2004.

If the member has no uncrystallised rights in the scheme before the lump sum is paid, the taxable amount is the total amount of the lump sum payment.

Example

Tom receives a trivial commutation lump sum of £10,000. This lump sum includes uncrystallised rights, which are valued at £5,000.

The member’s taxable pension income in respect of the lump sum payment is

£10,000 - (£5,000 @ 25 per cent) = £8,750.

As the payments are taxable as pension income the rate of tax is the member’s marginal rate of income tax for the tax year in which the lump sum is paid. The payer of the lump sum must operate PAYE on the taxable amount of the lump sum payment in accordance with the PAYE rules before paying the lump sum.

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Operating PAYE on the lump sum payment

For an uncrystallised funds pension lump sum, procedural guidance on operating PAYE was issued in Pension Schemes Newsletters No 66-68. This explained that normal PAYE rules apply to these payments. When a P45 may not be used, the Emergency Code should be used on a Month 1 basis until HMRC issues a tax code to operate against future payments (where appropriate).  The newsletters also advised on optional in-year claims procedures for members using forms P50Z, P53Z and P55 as appropriate.

For the other types of lump sums covered on this page that are subject to tax on pension income:

  • where the lump sum payment is in respect of a pension already in payment, the pension payer should use the PAYE code already in operation,
  • where the pension being commuted was not already in payment, the pension payer should use the basic rate (BR) tax code.

Guidance on how to operate PAYE correctly on these lump sums can be found in CWG2 - Employer’s further guide to PAYE and NICs. A copy of the CWG2 can be found on the GOV.UK website. There is also guidance for pension schemes on how to operate PAYE on the GOV.UK website. This includes guidance on how to operate PAYE on trivial commutation lump sums.

Because of the way PAYE works, using the BR code on these lump sum payments may mean that the member ends up paying too much tax. Where this does happen, the member can claim the tax back in-year. There is guidance for individuals on how to do this on the GOV.UK website.

The problem is that many of the people affected won’t know that they may have paid too much tax and so are entitled to a tax refund. For the people affected it would be helpful if scheme administrators could include advice on how to claim a refund when they issue the lump sum payment. Some suggested wording that could be used is shown below. This will also benefit the scheme administrator by reducing the number of enquiries they may get on how the lump sum has been taxed and claiming refunds.

Suggested wording

“Your form P45 details include the amount of tax deducted from your pension commutation lump sum. The tax deducted may not be the right amount due when all of your income for the year is taken into account.

After next 5 April HM Revenue & Customs will check if you have paid the correct amount of tax, and if not they will contact you. But if you think you have paid too much tax you can ask HM Revenue & Customs for a tax refund now - you do not have to wait until 5 April.

To claim a refund you can complete form P53 online without needing to contact HMRC directly. You should find this easier to do than completing the form manually. The form is available on GOV.UK website.

If you prefer to complete the form manually, call the Taxes Helpline on 0300 200 3300 and ask for form P53. It helps if you have your National Insurance number to hand when you call.”

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What happens when the limits on authorised lump sums are exceeded

Paragraph 12(5) Schedule 29 Finance Act 2004

If a registered pension scheme makes a lump sum payment that does not fit into any of the authorised lump sum payment definitions, it is an unauthorised member payment, and is taxed as such (see PTM130000).

Where a scheme makes a payment that meets the definition of an authorised lump sum payment, but the amount paid exceeds the limit specified in the legislation, this does not mean that the whole payment becomes unauthorised in all cases.

For the following lump sum payments:

  • a pension commencement lump sum - see PTM063200
  • a stand-alone lump sum - see PTM063130
  • a short-service refund lump sum - see PTM045000
  • a refund of excess contributions lump sum - see PTM045000 and
  • a winding-up lump sum - see PTM063600

the part of the payment that is within the limit is still an authorised lump sum payment. Any excess is not treated as being part of that lump sum payment, and will become either:

  • another form of authorised lump sum payment or scheme administration member payment (where it falls within the relevant definition), or
  • an unauthorised member payment

and will be taxed accordingly.

With the other forms of authorised member lump sum payments, either:

  • the limit is on the capital value of pension rights at a valuation date, rather than on the payment itself, so if the capital value exceeds the limit, the whole payment will fail to satisfy the conditions for that type of authorised lump sum (a trivial commutation lump sum), or
  • there is no limit on the amount of the authorised lump sum, although the amount paid is tested for lifetime allowance purposes (an uncrystallised funds pension lump sum, serious ill-health lump sum or lifetime allowance excess lump sum).

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Authorised lump sum payments and the lifetime allowance

Lump sum payments that use up lifetime allowance

Section 216(1), BCE 6; paragraph 1(1)(b), 4(1)(b), 11(a) and 12(2) Schedule 29 and paragraph 15 Schedule 32 Finance Act 2004

The following authorised lump sum payments trigger a lifetime allowance test (through benefit crystallisation event 6 (BCE 6) - see PTM088670):

  • a pension commencement lump sum
  • an uncrystallised funds pension lump sum
  • a serious ill-health lump sum, and
  • a lifetime allowance excess lump sum.

These are collectively referred to in the legislation as ‘relevant lump sums’.

The amount that crystallises for lifetime allowance purposes upon payment of the above lump sums is the amount actually paid.

Before a pension commencement lump sum or an uncrystallised funds pension lump sum (paid before the member has reached age 75) is paid the scheme administrator needs to establish whether the member has sufficient lifetime allowance available to cover the payment (and any other benefit under the scheme which the lump sum is connected with). In contrast, a lifetime allowance excess lump sum can only be paid where there is no available lifetime allowance and there is a chargeable amount arising at the BCE. With the payment of a serious ill-health lump sum the individual must have available lifetime allowance for the payment to be made, but the size of the payment is not limited by the level of lifetime allowance actually available.

For an uncrystallised funds pension lump sum, the tax-free element of the lump sum payment is restricted where the amount of the lump sum exceeds the member’s available lifetime allowance.

Lump sum payments that do not use up lifetime allowance

Paragraph 7(1)(c) and 10(1)(d) Schedule 29 and Schedule 32 Finance Act 2004

Payment of any of the other authorised member lump sums does not trigger a lifetime allowance test through BCE 6, and the amount paid will not use up any of the member’s lifetime allowance.

A trivial commutation lump sum or a winding-up lump sum may, however, only be paid where the member has not exhausted their entire lifetime allowance. The member must have available lifetime allowance. This restriction does not apply to the payment of a short service refund lump sum or refund of excess contribution lump sum.

For the avoidance of doubt, where the member has used up 100 per cent of their lifetime allowance and a short-service refund lump sum or refund of excess contribution lump sum is paid, those payments will not be subject to a lifetime allowance charge.

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Member’s entitlement to an authorised lump sum payment

Section 166(2) and paragraphs 1 to 3 Schedule 29 Finance Act 2004

For the purposes of the tax legislation, a person normally becomes entitled to a lump sum at the time the person acquires an actual right rather than a prospective right to receive the lump sum benefit. The change occurs at the point the person has become actually entitled to receive the lump sum.

The exception to this is where a pension commencement lump sum is being paid. Here, entitlement is deemed to arise immediately before the person becomes entitled to the pension benefit which the pension commencement lump sum is linked to (see PTM063210). So the lump sum entitlement arises on the same day as the linked pension entitlement, but is deemed to arise before the pension entitlement. This can make a difference where the member is approaching their lifetime allowance (see PTM088200).

The lump sum payment can qualify as a pension commencement lump sum as long as it is paid within an 18-month period, starting 6 months before and ending 12 months after the date the member becomes entitled to it.

Where the member receives a lump sum in anticipation of becoming entitled to the relevant pension, but then dies before that entitlement arises, the legislation deems the member to have become entitled to the lump sum immediately before death. This means that the lump sum payment becomes an authorised payment, providing it did not exceed the member’s available lump sum allowance immediately before the member died, and providing the other conditions for a pension commencement lump sum are satisfied.

The Registered Pension Schemes (Authorised Payments) Regulations 2009 - SI2009/1171

These Regulations authorise certain lump sums paid from a registered pension scheme to or in respect of a member:

  • where the payment results in a small lump sum (see PTM063700), or
  • in circumstances involving certain errors (see PTM062800).

The entitlement to small lump sum payments typically arises when the right to actual payment arises. In the case of pension commencement lump sum errors, entitlement arises on the basis already described above for pension commencement lump sums. Where the entitlement to pension commencement lump sum payments is only established after death, the entitlement to the portion of the payment that is authorised by these regulations can be said to have arisen for tax purposes at the point in time immediately before death.

Commuted equivalent pension benefits (EPBs)

Section 164(1)(f) Finance Act 2004

Regulation 2(a) The Registered Pension Schemes (Authorised Payments) Regulations 2006 - SI 2006/209

In addition to the authorised payments under the ‘lump sum rule’, regulations can also provide that other types of lump sum can be authorised payments when they are made by registered pension schemes.

Regulations have been made to cover the payment of certain lump sums representing commuted equivalent pension benefits (contracted-out rights earned between 1961 and 1975). Such a payment is an authorised payment providing it is made in accordance with the relevant Department for Work and Pensions legislation (as described in regulation 2(a) of SI 2006/209).

HM Revenue & Customs legislation does not impose any additional conditions on payments of this type for them to be authorised payments. In particular, no ‘trivial commutation’-type valuation test is necessary for the payment of commuted EPBs to be an authorised payment. However, if other pension rights are to be commuted and paid under the trivial commutation lump sum provisions, the value of any EPBs must be taken into account for the purposes of comparing the value of the member’s total pension rights with the commutation limit, which for commutation periods starting on or after 27 March 2014 is £30,000.

Payments of lump sums representing commuted equivalent pension benefits are taxed in the same way as trivial commutation lump sums - see PTM063500.