This pension commencement lump sum (PCLS) could be taken each time benefits were crystallised until the LTA was exhausted. Yes, there were some protections, but a rising LTA would make these easily navigable.
In the event, we are now in a situation where individuals have either an unlimited LTA (enhanced protection), a multiple of £1.8m (primary protection), £1.8m, £1.5m, £1.25m, £1m, or somewhere between £1m and £1.5m (individual protection 14 and 16). All of this has an impact on what PCLS can be taken by individuals.
The basics
For those with a simple defined contribution pension scheme who take the PCLS as a single payment, the calculation is just as imagined in 2006: 25 per cent of the fund, up to the maximum allowed by their LTA.
For those in a defined benefit or final salary scheme, it is a little more complicated. There is no identifiable fund in these cases, but it effectively equates to 25 per cent of the capital value of the pension and lump sum. This usually means a chicken-and-egg calculation; a process that establishes how much lump sum an individual can have based on the amount they are taking.
Enhanced or primary protection
Those that applied for enhanced protection in relation to their benefits accrued before 6 April 2006 (A-day), would also have gained a measure of protection on their tax-free cash entitlements, as long as they had a claim of more than £375,000.
The enhanced protection certificate issued by HMRC would have included a percentage figure. This figure gives the individual the right to a PCLS corresponding to that figure: if the amount quoted is 20 per cent, the individual will be entitled to a lump sum of 20 per cent of their fund, with no test against the LTA.
If the member has been granted primary protection and the tax-free cash at A-day exceeded £375,000, the general rule is that the tax-free lump sum calculated at 5 April 2006 is protected and escalates in line with increases in the standard LTA (or 20 per cent if higher).
For the purposes of primary protection, the standard LTA is assumed to be £1.8m. When primary protection is granted, HMRC’s certificate confirms the amount of protected cash. Unlike enhanced protection, the cash sum may be taken from any scheme and in any proportion. This theoretically means it may be possible to take the whole of one pension fund as tax-free cash.
It may have been the case that the individual could not have protected their tax-free cash because it was below £375,000 at A-day. In these scenarios, the certificate will not show a percentage or figure for protection. However, in both cases the client’s LTA is assumed to be £1.5m for the purposes of the tax calculation at the point when the tax-free cash is taken.
Scheme-specific protection
One of the main issues currently arising is scheme-specific tax-free cash. This is where an individual was in an occupational pension scheme before A-day that entitled them to more than 25 per cent of the fund as a tax-free lump sum.
In these cases, the way in which the cash was calculated in occupational schemes wasn’t related to the fund value, instead being calculated based on salary earned and the time they worked for the relevant employer. It meant that these individuals could accrue a large proportion of cash in a scheme in comparison to their actual fund value. This was protected within the scheme at A-day and revalued to the present day, and any additional growth in the scheme could pay out a further 25 per cent.
However, Box One and Box Two show how scheme rules can mean differing outcomes for those with the same starting level of pension savings. The different LTA protections will impact on these figures, and those with higher levels would be entitled to a lower lump sum when it is paid. This is an odd anomaly. Even the increase in the LTA in April will mean that some will get a lower PCLS.
There are some individuals whose entitlements to tax-free cash at A-day were so large that their whole fund could be paid out. This isn’t impacted by the changes in the LTA, provided these individuals did not make any contributions after A-day. If the whole fund was tax-free cash at A-day, it still can be paid out as a standalone lump sum.
Scheme-specific tax-free cash should be protected, but if the scheme doesn’t offer the income options required, then there may be no option but to give up this benefit.
It isn’t possible to take a PCLS from one scheme and then transfer the residual to get access to drawdown – initially, it all has to happen in the same scheme. This will mean that many will be forced to choose between a higher PCLS or the pension freedoms. That said, in certain circumstances a transfer before taking benefits, which will retain the enhancement, is possible.
Taking benefits in stages
The main issue with tax-free cash at the moment is that taking benefits in stages can reduce the overall amount of cash that the individual can access. Phasing benefits has many other positives and all considerations should be weighed up before any decision is made about how retirement benefits are taken.
The reason this has occurred is because an individual can only take 25 per cent of the available portion of their remaining LTA. The amount taken is revalued to take account of the changes to the allowance.
Should an individual have a different LTA due to protection, it will mean that more of the this amount will have deemed to have been used up. The tax-free cash amount may be restricted as a result.
In addition, for those with different types of schemes, such as a defined benefit and a defined contribution plan, then the order in which the benefits are taken will impact what the individual will be able to take from the other scheme – should they be limited by the LTA.
Payments after the age of 75
It is possible to avoid access to pension benefits until after the age of 75 if they are not required. Although they are tested against the LTA at age 75, this doesn’t mean that the entitlement to a PCLS is lost. Any entitlement can be accessed using the same rules as those in force pre age 75. However, the LTA is assessed as if the test at age 75 hasn’t occurred.
It should be noted that on death after the age of 75, the whole fund will be subject to income tax when it is drawn, so the tax-free element will be lost.
PCLSs are complex, and establishing entitlement and avoiding losing out requires a good understanding of all the issues. This is particularly important if a transfer of pension benefits from one scheme to another is occurring. The way in which benefits are accessed can also have consequences.
No one wants to pay more tax than they have to, so getting appropriate advice is key to the best outcome in retirement. After all, there are many factors to consider and the level of tax-free cash is only one of them.
Claire Trott is head of pensions strategy at Technical Connection
