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HMRC internal manual

Pensions Tax Manual

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Member benefits: lump sums: Pension commencement lump sum (PCLS): general limits information

Glossary PTM000001
   

The maximum level of pension commencement lump sum payable
Protection of pension commencement lump sum entitlements that arose before 6 April 2006
Payment of a pension commencement lump sum where there is a disqualifying pension credit
Why the entitlement to a pension commencement lump sum where funds are designated for drawdown pension is linked to an arising entitlement to income withdrawal
When an entitlement to a pension commencement lump sum arises in connection with a scheme pension
Lump sum-only schemes or arrangements

The maximum level of pension commencement lump sum payable

Paragraph 2 and 3, Schedule 29 Finance Act 2004

The maximum level of pension commencement lump sum that can be paid under an arrangement at a given time is referred to as the ‘permitted maximum’.

A scheme can pay a member a higher lump sum, if they so wish. But any amount over the permitted maximum will not be a pension commencement lump sum. However, if the excess payment was paid with the intention of being a pension commencement lump sum and is authorised under the Registered Pension Schemes (Authorised Payments) Regulations 2009 - SI 2009/1171, then it will be accepted as being an authorised payment. For the purposes of the tax rules, it will be treated as a pension commencement lump sum (see PTM063260). If none of the above-mentioned regulations apply, it will be an unauthorised member payment and taxed accordingly.

Definition of permitted maximum

Paragraph 2 Schedule 29 Finance Act 2004

The permitted maximum is defined in the legislation as being the lower of two amounts. These are:

  • the available portion of the member’s lump sum allowance - this is an amount equal to 25% of the member’s lifetime allowance available at that time, and is calculated on the basis that the member is entitled only to the standard lifetime allowance (see PTM081000), but where the member’s entitlement to the lump sum arose after 5 April 2014 and the member has primary protection or valid enhanced protection at that time and the standard lifetime allowance is less than £1.5 million, use £1.5 million in the calculation instead, and
  • the applicable amount - this represents 25% of the capital value of the benefits coming into payment under the relevant arrangements under the scheme generating the lump sum payment, but ignoring any disqualifying pension credit held and, where a money purchase arrangement is involved, ignoring any drawdown pension funds that have already been designated. See PTM062730.

However, where a member has received a lump sum payment in anticipation of the entitlement to their scheme pension, lifetime annuity or income withdrawal arising within 6 months, but has died before that entitlement has arisen, the lump sum payment can be treated as a pension commencement lump sum to the extent that it does not exceed the amount of the available portion of the member’s lump sum allowance immediately before their death. The applicable amount calculation does not come into play.

The details immediately below deal with the various transitional issues that may affect this limit.

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Protection of pension commencement lump sum entitlements that arose before 6 April 2006

Paragraphs 24 to 34 Schedule 36 Finance Act 2004

In certain circumstances a pension commencement lump sum may be paid that exceeds the normal 25% applicable amount. This is where the member was entitled (or prospectively entitled) to a lump sum benefit representing a higher percentage of their benefits on 5 April 2006. The permitted maximum is altered to reflect this retained right. PTM063100 onwards sets out the different forms of protecting lump sum rights at 5 April 2006.

Where the member has primary protection and lump sum rights of more than £375,000 on 5 April 2006, the available portion of the member’s lump sum allowance is replaced by a different (higher) figure. PTM063110 explains how primary protection and protection of lump sum rights works.

Where the member has enhanced protection and lump sum rights of more than £375,000 on 5 April 2006, the permitted maximum is the proportion of the fund that could have been taken as a lump sum benefit on 5 April 2006. PTM063120 gives the explanation of how enhanced protection and protection of lump sum rights works.

PTM063130 onwards explains the position for members who do not have primary or enhanced protection and whose uncrystallised lump sum rights were more than 25% of their uncrystallised pension rights on 5 April 2006.

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Payment of a pension commencement lump sum where there is a disqualifying pension credit

Paragraphs 2(1) to (5), 3(2), (5)(b) and (8)(b) Schedule 29 Finance Act 2004

If all or part of the benefit entitlement from a registered pension scheme comes from a ‘disqualifying pension credit’, those pension credit rights are not included when calculating the maximum applicable amount of pension commencement lump sum that can be paid.

As the permitted maximum is the lower of the applicable amount and the available portion of the member’s lump sum allowance then, where all the member’s rights under an arrangement relate to a disqualifying pension credit, the permitted maximum is nil (as the applicable amount is nil). So a lump sum cannot be treated for tax purposes as a pension commencement lump sum in such cases. This will not change no matter how high the available portion of the member’s lump sum allowance is.

Where only part of the arising benefit entitlement represents a disqualifying pension credit the applicable amount is discounted proportionately.

Definition of a disqualifying pension credit

Paragraph 2(3) and (4) Schedule 29 Finance Act 2004

A pension credit is a disqualifying pension credit if at the time the pension credit was created, the member’s ex-spouse or former civil partner’s pension that was being shared with the member was actually in payment.

If the pension credit arose from the member’s ex-spouse or former civil partner’s benefit that had not yet come into payment at that time, it is not a disqualifying pension credit. The position is not affected where the member’s ex-spouse‘s or former civil partner’s benefits come into payment after the creation of that pension credit.

Reason for exclusion

The purpose behind this exclusion is to ensure that where a pension in payment is split through a pension sharing order, the person who is provided with the pension credit will not be able to take a tax-free lump sum from the benefit rights that are acquired. This is on the basis that when the member’s ex-spouse or former civil partner’s benefits first came into payment, that ex-spouse or former civil partner will have taken (or had the opportunity to take) a tax-free lump sum in respect of the benefits, so it would not be appropriate to allow a lump sum to be taken free of income tax from the pension credit rights. This applies regardless of whether a lump sum was actually taken by the pension debit member.

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Why the entitlement to a pension commencement lump sum where funds are designated for drawdown pension is linked to an arising entitlement to income withdrawal

Section 165(3)(a); paragraph 7 Schedule 28 and paragraph 3(1) Schedule 29 Finance Act 2004

When designating uncrystallised funds to provide a drawdown pension, the legislation links the pension commencement lump sum to the arising entitlement to income withdrawal, rather than an entitlement to a drawdown pension (paragraph 3(1), Schedule 29 Finance Act 2004).

A lump sum can be treated for tax purposes as a pension commencement lump sum only when pension benefit entitlement first arises from uncrystallised rights or funds. This occurs at the point uncrystallised funds are designated to provide a drawdown pension. The lump sum is not paid from the arising drawdown pension fund or flexi-access drawdown fund, but from a proportion of the uncrystallised funds alongside those being designated to generate the drawdown pension fund or flexi-access drawdown fund.

Where funds are designated to provide a drawdown pension, the initial pension entitlement arising at that time will always be an entitlement to income withdrawal, and not to a short-term annuity income. This is because the legislation states that entitlement to income withdrawal arises at the point uncrystallised funds are designated to provide a drawdown pension (section 165(3)(a) Finance Act 2004). So this is the point at which a lump sum can be treated for tax purposes as a pension commencement lump sum. The lump sum may of course have been paid earlier (within the 6 month period before the entitlement to the income withdrawal arose), or it may be paid up to 12 months later. Entitlement to income withdrawal arises at that point, whether or not income withdrawals are actually paid.

Entitlement to a short-term annuity arises only when that contract is purchased. This will always occur after the initial designation to provide drawdown pension, and will be purchased from the drawdown pension fund or flexi-access drawdown fund rather than from uncrystallised funds. So as far as the legislation is concerned, entitlement to a short-term annuity will always arise after an entitlement to income withdrawal.

Because the legislation links the pension commencement lump sum to the pension entitlement that arises at the actual point uncrystallised funds are designated to provide drawdown pension, which is the entitlement to income withdrawal, a lump sum payment cannot be treated as a pension commencement lump sum where an existing drawdown pension fund or flexi-access drawdown fund is used to purchase a lifetime annuity contract, applied to provide a scheme pension, or used to purchase a short-term annuity. A further tax-free lump sum payment will only be possible where further uncrystallised funds are designated for drawdown.

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When an entitlement to a pension commencement lump sum arises in connection with a scheme pension

Section 165(3) Finance Act 2004

Entitlement means an actual right to receive the pension

A lump sum can only be treated for tax purposes as a pension commencement lump sum in connection with an arising entitlement to a relevant pension under the same registered pension scheme. A pension commencement lump sum cannot be paid in connection with a pension while it is deferred (which is what the legislation refers to as a ‘prospective’ right to a pension).

The definition of scheme pension refers to an amount that is payable rather than paid, which can cover situations where a person cannot be traced. In such a case, if the scheme rules so provide, a pension benefit can have become payable, as opposed to a deferred pension which does not become payable during the period of deferral.

Where a lump sum was paid before 6 April 2006 in respect of a deferred pension entitlement

There are transitional issues relating to certain pension entitlements in deferment on 5 April 2006, where a lump sum entitlement had already been drawn in connection with that pension benefit. The position here is explained at PTM063210.

Where a member dies after having received a lump sum

Paragraph 1(1)(aa) Schedule 29 Finance Act 2004

A lump sum payment may be treated as a pension commencement lump sum if it is paid within an 18-month period starting 6 months before and ending 12 months after the member’s entitlement to it arises. Entitlement to a pension commencement lump sum arises immediately before the entitlement to the relevant pension to which the lump sum is related. But if the member dies having received a lump sum, but before the entitlement to the pension has actually arisen, the legislation deems the entitlement to the lump sum to have arisen immediately before the member’s death. This makes the lump sum an authorised payment as long as the other conditions for a pension commencement lump sum are satisfied.

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Lump sum-only schemes or arrangements

Paragraphs 1-3 Schedule 29 Finance Act 2004

Paragraph 34(2) Schedule 10 Finance Act 2005

The normal rules are that a lump sum payment can only be treated for tax purposes as a pension commencement lump sum where the member becomes entitled to actually receive a pension benefit from an arrangement under a registered pension scheme. The payment may be made up to 6 months before and 12 months after the entitlement to the pension benefit arises. The amount of such a lump sum is capped by reference to the level of the associated pension benefit entitlement arising under that arrangement or scheme, as well as by the member’s available lump sum allowance, with any excess being an unauthorised member payment.

Lump sum-only schemes

The maximum authorised payment will normally never be more than 25% of the accrued rights arising at that time under the scheme (the applicable amount). So it is not normally possible for all of the funds or rights held under a registered pension scheme in respect of a member to be paid as a pension commencement lump sum. But there is an exception where the member held rights in a scheme to take benefits wholly in lump sum form at 5 April 2006, in certain circumstances (see PTM063140).

A registered pension scheme that paid a higher lump sum benefit before 6 April 2006 (such as schemes that provide lump sum benefits only) cannot provide such a lump sum to members who joined on or after this date, without triggering an unauthorised member payment.

Lump sum-only arrangements

The tax legislation allows schemes some flexibility in paying different types of benefit from different arrangements in the same scheme. A pension commencement lump sum can be paid from one arrangement based upon an arising pension entitlement under another of the member’s arrangements under the scheme. This means that a member can be given the choice of drawing their pension commencement lump sum from one source under a scheme, provided they have sufficient pension entitlement arising somewhere else in the scheme.

For example, if a scheme is set up in such a way as to hold the member’s additional contributions (AVCs) in a separate arrangement to that of the main scheme benefit, the member may choose to take their permitted lump sum entitlement under the scheme from their AVC arrangement, rather than through commutation of their main scheme benefits. This lump sum can still qualify as a pension commencement lump sum.

Example

Terry holds uncrystallised benefits under two arrangements in a registered pension scheme.

Under arrangement A, Terry is entitled to a scheme pension of £10,000 per annum. A pension commencement lump may be paid by commuting part of this pension entitlement.

Arrangement B is a money purchase arrangement holding £100,000 of uncrystallised funds. The scheme rules state that these funds can only be used to purchase a lifetime annuity, although a lump sum may be provided by commutation.

The scheme rules give Terry the option of taking his lump sum entitlement under arrangement A through arrangement B. This effectively allows him to aggregate his lump sum entitlements under both arrangements A and B in arrangement B.

Terry draws a £75,000 pension commencement lump sum from arrangement B, using the remaining £25,000 to purchase a lifetime annuity. Arrangement A provides the full £10,000 per annum scheme pension.

The lump sum paid under arrangement B is justified on the basis of Terry’s total pension entitlements arising under the scheme.

The applicable amount based on his arising scheme pension entitlement arising under arrangement A is £66,667 (£66,667 + £200,000 {£10,000 x the relevant valuation factor of 20}, divided by four - see PTM063240).

The applicable amount based on the lifetime annuity purchase under arrangement B is £8,333 (one third of the annuity purchase price of £25,000 - see PTM063240).

The total applicable amount is therefore £75,000. Terry has not crystallised benefits up to the standard lifetime allowance so the available portion of the member’s lump sum allowance does not restrict the applicable amount of £75,000.