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Commuting a small pension fund for cash

If the value of pension benefits is below a specified amount a scheme member may have the option to take their benefits as a lump sum.

A lump sum can be taken using one of the following rules:

• A small pot lump sum (defined contribution and defined benefit schemes)
• A trivial commutation lump sum (defined benefit schemes only)
• A winding-up lump sum (occupational schemes only)

Individuals who are members of a pension scheme that offers either flexi-access drawdown or the uncrystallised funds pension lump sum (UFPLS) can achieve a similar result by taking a lump sum from these schemes, but the small pots/triviality rules have the advantage of not using up any lifetime allowance or triggering the money purchase annual allowance (MPAA).

The triviality rules are also available on death. This means a survivor can also commute a small pension as a trivial lump sum.

Small pot lump sums

Both defined contribution and defined benefit schemes can pay out a commuted lump sum under the small lump sum provisions, commonly referred to as 'small pot rules'. Crystallised and uncrystallised benefits can be taken using these rules if the member has reached age 55, meets the criteria for ill-health, or has a protected pension age. In addition:

Personal pensions

• The value of the arrangement must be £10,000 or less
• The payment must extinguish all the members rights under that arrangement
• Payments of this type can be made up to three times

Occupational pensions

• The value of the scheme must be £10,000 or less.
• The payment must extinguish the member's rights under that scheme.
• There is no limit to the number of times this option can be used.
• The member must not be a controlling director (or connected to a controlling director) of the sponsoring employer.
• There have been no transfers out within the last three years.

Pension arrangements

It's important to note that for personal pensions the £10,000 limit applies to the value of a 'pension arrangement' rather than the value of the pension scheme. A personal pension scheme could be made up of several smaller pension arrangements, so each might qualify for small pot commutation even if the overall value of the scheme exceeds £10,000.

For occupational pensions, the total value of the pension scheme must be £10,000 or less.

Additional situations when the small pots rules apply

The small pots rules can also be used when:

• the member has taken protected tax free cash leaving a small fund of £10,000 or less to provide a pension, or
• a member who had taken their benefits, or transferred them to another scheme, is later found to be entitled to additional benefit from the scheme valued at £10,000 or less

Full details of the conditions which need to be met to allow such payments can be found at PTM063700 in HMRC's Pensions Tax Manual.

Lifetime allowance

There is no requirement for the member to have any lifetime allowance and any lump sum paid does not use up lifetime allowance.

The money purchase annual allowance (MPAA) is not triggered.

Trivial commutation lump sums - defined benefits

In addition to small pots rules, defined benefit schemes are allowed to provide a trivial commutation lump sum if the total of all the member's pension benefits are valued at £30,000 or less.

Where benefits are taken in this way, the payment must extinguish the members defined benefit rights in the scheme.

A scheme that also has a money purchase section could still commute a member's defined benefit rights leaving just money purchase fund remaining.

Whilst the £30,000 limit may appear more generous than the small pots limit, it's important to note that this value includes the member's pension rights in all registered pension schemes, including the value of personal pensions, defined contribution occupational schemes and schemes already in payment.

Benefits are valued on a date chosen by the scheme member, known as the 'nominated date'. If the value of pension benefits are within the £30,000 limit, benefits can be taken under the triviality rules. If the value of benefits subsequently increase to above the £30,000 limit after the nominated date, benefits can still be taken as long as they are paid before the payment deadline.

The lump sum must be paid within three months of this nominated date. Where multiple schemes are involved, this only applies to the first payment and any subsequent payments must be made within 12 months of the first payment. No further trivial commutation lump sums can be paid after this 12 month period.

Any trivial commutation that took place before 6 April 2006 is ignored and not included in the £30,000 valuation.

Lifetime allowance

A trivial commutation lump sum can only be paid if the member has some lifetime allowance remaining, even though the payment of the lump sum doesn't actually use lifetime allowance.

The money purchase annual allowance (MPAA) is not triggered.

Winding-up lump sums - occupational schemes

The triviality rules can be used where a defined benefit or defined contribution occupational pension scheme is being wound up.

The requirements are:

• The occupational pension scheme is winding-up
• The value of their pension rights under that scheme is within the trivial commutation limit of £18,000 - pension rights in other schemes can be ignored
• There is no minimum age to take a winding-up lump sum.
• The payment extinguishes all the rights under that scheme
• If the employer made contributions to that scheme in the last five years for the member receiving the winding-up lump sum the employer must:
  
  
  • not make contributions under any other registered pension scheme for the member, and
  • confirm to HMRC it won't make any contributions for at least a year from the date the winding-up lump sum is paid

Lifetime allowance

A winding-up lump sum can only be paid if the member has some lifetime allowance remaining, even though the payment of the lump sum doesn't actually use lifetime allowance.

Trivial commutation on death - survivor benefits

Small pensions from both defined benefit and/or defined contribution schemes, payable to a survivor on the death of member can be commuted and paid as a one off lump sum (known as a trivial commutation lump sum death benefit) provided the value of the lump sum in each scheme is no more than £30,000.

The lump sum can be paid to an individual who is entitled to receive either:

• A small dependant's/survivor's pension, or
• The remaining instalments of a member's pension paid within the guarantee period under a lifetime annuity or scheme pension

The trivial payment must extinguish the dependant's/survivor's entitlement to pension and lump sum death benefits under the scheme in respect of the deceased member.

The survivor's triviality rules can also be used where GMP or section 9(2B) rights are involved.

When valuing the dependant's/survivor's benefits, lump sum death benefits (e.g. death in service benefits) payable from the scheme can be disregarded and paid in addition to any trivial commutation lump sum death benefit.

There are no age restrictions; a commutation lump sum can be paid regardless of the age of the member/survivor.

Lifetime allowance

A trivial commutation lump sum death benefit is not a benefit crystallisation event and taking benefits in this way does not use up either the deceased member's or the recipient's lifetime allowance.

Valuing benefits

Benefits taken under the small pots and triviality rules must be valued to ensure that they don't exceed either the small pots or triviality limits.

Generally speaking, the method of valuation is similar to that used for lifetime allowance purposes, but with a few adjustments in respect of crystallised benefits (that is, benefits which are already in payment).

Uncrystallised benefits

The way in which uncrystallised pension benefits are valued depends on the type of arrangement they're held in.

• Money purchase schemes - the market value of the fund
• Defined benefit schemes - 20 times the yearly pension plus any separate tax free cash
• Cash balance - the amount that would be available to provide an immediate benefit if the member was entitled to it on the valuation date, i.e. nominated date
• Hybrid arrangements - the higher of the defined benefit or money purchase value

Crystallised benefits

The way in which crystallised pension benefits are valued depends on whether they were drawn before or after 6 April 2006.

• Benefits drawn before 6 April 2006
  
  Multiply the yearly pension in payment as at 5 April 2006 by 25. There's no need to consider any tax free cash taken as this is taken into account by the conversion factor of 25.
• Benefits drawn on or after 6 April 2006
  
  The value of the benefits tested against the lifetime allowance at any previous crystallisation event - with no adjustment for any changes to the lifetime allowance.
  
  The scheme administrator must give the member details of the amount crystallised under the scheme at any benefit crystallisation event.
  
  

  Example - Aisha has a small defined benefit scheme valued at £11,500 and wants to know if she can use the triviality rules. At A-Day (6 April 2006) she had a pension in payment of £760 a year. She also crystallised a small personal pension in 2007/08 worth £4,000. For triviality purposes these are valued at:

  Pre 6 April 2006 benefits - £760 x 25	= £19,000
  Post 5 April 2006 benefits	= £4,000
  The total value of crystallised benefits	= £23,000
  Plus value of small defined benefit scheme	= £11,500
  Total value of pension benefits	= £34,500

  As the total value of Aisha's benefits are more than £30,000 she cannot take the fund under the triviality rules. And as the value of the defined benefit scheme is over £10,000, she can't use the small pots rules either.

Taxation of small pots and trivial lump sums

If a small pot lump sum, trivial commutation lump sum, or winding-up lump sum is paid from uncrystallised rights, 25% of the lump sum is paid tax free. The balance is taxed as part of the member's income for the tax year in which the lump sum is paid.

Members with protected tax free cash of more than 25% of the fund are likely to lose their high tax free cash entitlement if benefits are taken using these rules. The only exception is where the residual fund after the protected tax free cash has been paid comes to less than £10,000, then it may be possible to commute this for a lump sum using one of the variations of the 'small stranded pots' rules.

Details of the conditions which need to be met to allow such payments can be found at PTM063700 in HMRC's Pensions Tax Manual.

If a lump sum for the member is paid from crystallised rights, or a lump sum is made by commuting a survivor's pension or the remainder of a guaranteed period as a trivial commutation lump sum death benefit, the whole lump sum is taxed as income.

For the taxable part of any commuted lump sum payment, the scheme administrator must deduct any income tax under the PAYE procedures:

• Where the lump sum payment is in respect of a pension already in payment, it should be possible to use the PAYE code already in operation.
• Where this is the first payment, the basic rate (BR) tax code is used.

If this results in an overpayment of tax, the individual can reclaim the overpaid amount using HMRC form P53 But higher or additional rate taxpayers may need to pay more tax through self-assessment.