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Tax-free cash - the basics

When can tax-free cash be paid? 

Tax-free cash is available from normal minimum pension age (currently 55), or earlier on ill-health or if the individual has a protected low pension age.

Under some schemes, benefits may have to be taken by age 75, but this is not a legislative requirement and many schemes do allow it to be taken after reaching age 75. However, if tax-free cash is deferred beyond age 75 but the individual dies before it’s taken, the tax-free element is lost, and any income or lump sums paid to the beneficiaries would be subject to their marginal rate of income tax.

Tax-free cash normally* can only be paid if pension benefits within the scheme are also being brought into payment (or crystallised, as it's known) at the same time. This is why the official term for tax-free cash is a pension commencement lump sum (PCLS).

The right to tax-free cash from an arrangement is normally lost if an individual chooses not to take tax-free cash when they crystallise benefits.

Income doesn't always have to be taken to access tax-free cash. Where a contract offers income drawdown, it would be sufficient for the funds to be designated for drawdown and for the individual to choose nil income.

* There are a few exceptions where tax-free cash can be taken without there being an associated pension – for example, where tax-free cash is paid in isolation under the transitional protection rules for stand-alone lump sums (see our guide ‘Scheme specific tax-free cash protection’ for details).

How much can be paid?

Generally, up to 25% of the value of benefits crystallised under an arrangement can be paid as tax-free cash. For example, if a personal pension fund of £200,000 is crystallised, tax-free cash of up to £50,000 can normally be paid. However, there are some circumstances where an individual's tax-free cash rights can be higher or lower than 25% - more on this later.

There’s also an overall limit across all schemes:

• From 6 April 2024 – the maximum tax-free cash available to the individual in total is capped by the ‘lump sum allowance’ (LSA). The standard LSA is £268,275 (25% of the former lifetime allowance). Those with transitional protections can have a higher LSA.
• Before 6 April 2024 – tax-free cash was generally limited to 25% of the individual’s available 'lifetime allowance' (LTA). If the individual’s LTA had been fully used up, no tax-free cash could be paid. The standard LTA was £1,073,100 just before it was abolished. Those with transitional protections had a higher LTA.

Normally where someone has more than one pension scheme, each scheme will pay out tax-free cash based on the value of benefits crystallised in that scheme. It generally isn't possible to take all tax-free cash entitlement from one scheme and pension from the remaining schemes.

The exception to this general rule is where an individual's total tax-free cash rights were valued at more than £375,000 on 5 April 2006 and they registered for primary protection. In this situation, the tax-free cash can be taken from different pension schemes at different times and in different proportions - provided the total taken from all schemes isn't more than the protected amount.

Pension commencement excess lump sums

Where an individual would normally be entitled to tax-free cash from a scheme, but is restricted because they don’t have enough LSA remaining, the lump sum can still be paid, but it won’t be tax-free. Following the abolition of the LTA, a new authorised lump sum has been created to cover this situation.

The excess lump sum over the available LSA can be paid as a ‘pension commencement excess lump sum’ (PCELS). This will be subject to income tax at the member’s marginal rate.

Lump sum allowance (LSA)

With the abolition of the LTA from 6 April 2024 came the introduction of two new allowances which limit tax-free lump sums paid from registered pension schemes – the ‘lump sum allowance’ and the ‘lump sum and death benefit allowance’ (LSDBA).

The LSA is a limit on certain lump sums paid during the member’s lifetime, whereas the LSDBA also includes serious ill-health lump sums and certain lump sum death benefits paid on death before age 75. 

The standard LSA is £268,275 for those without transitional protection.

The payment of the following lump sums on or after 6 April 2024 are ‘relevant benefit crystallisation events’ (RBCEs) and count towards the LSA:

• Pension commencement lump sums (PCLS) – the whole of the PCLS normally counts towards the LSA.
  
  However, if scheme-specific tax-free cash protection applies then the excess over 25% of the value of benefits crystallised is ignored. For example, if the benefits crystallised were £600,000 and scheme-specific tax-free cash protection provided a PCLS of £250,000, only £150,000 (25% of the benefits crystallised) would count towards the LSA and the £100,000 excess tax-free cash is ignored.
• The tax-free element of an UFPLS payment – an ‘uncrystallised funds pension lump sum’ is a way to take money purchase pension funds as a lump sum (or series of lump sums) without having to buy an annuity or go into drawdown.
• Stand-alone lump sums – where an individual had the right to take 100% of the value of their scheme as a tax-free lump sum as at 5 April 2006. The tax-free element is now limited to the value that could have been paid on 5 April 2023. As with a PCLS where scheme-specific tax-free cash protection applies, the excess over 25% is ignored (unless they have registered lump sum rights under primary or enhanced protection).

When calculating the remaining LSA available at a RBCE, any of the above lump sums previously taken since 6 April 2024 should first be deducted. Transitional rules apply where benefits have been taken before 6 April 2024.

Even though there’s a tax-free element to them, trivial commutation lump sums, winding up lump sums and small pot payments do not use up any of the individual’s LSA or LSDBA.

Lump sums which use up LSA also count towards the LSDBA, so they will reduce the available LSDBA on death.

LSA and transitional protections

The standard LSA doesn’t apply to those with transitional protections – they have a higher allowance:

Benefits taken pre-6 April 2024 – remaining LSA

Where benefits have been taken before 6 April 2024, an adjustment to the available LSA must normally be made to account for tax-free cash already taken.

Transitional rules offer two possible ways to do this.

However, these transitional rules do not apply to individuals with registered tax-free cash rights under enhanced or primary protection. 

Standard calculation – LTA usage

When testing against the LSA, the standard calculation will normally deduct 25% of the LTA used up by benefits taken before 6 April 2024, even in situations where no tax-free cash was taken. This will be the default option.

If 100% of the LTA has been used up, the LSA and LSDBA will be set to £0 for the standard calculation. For this reason, it may be beneficial for some individuals to use the alternative method, even if only to improve their LSDBA position.  

If pension benefits came into payment before 6 April 2006 (i.e. pre-A-Day) but there were no BCEs from 6 April 2006 to 5 April 2024, the pre-A-Day pension must be valued to see how much of the LSA and LSDBA has been used up. This is calculated as 25% of 25 times the annual pension in payment at the first RBCE.   

Alternative calculation - transitional tax-free amount certificate (TTFAC)

The transitional rules provide for an alternative calculation that can benefit some individuals by increasing their remaining LSA and, therefore, allow more tax-free cash than under the standard calculation.

This option is there for individuals who can evidence the exact amounts of tax-free cash they actually received in the past. This then allows them to apply for a ‘transitional tax-free amount certificate’ (TTFAC) confirming the aggregate amount to be deducted from their available LSA.

Clients who potentially could receive more tax-free cash by obtaining a TTFAC include those who:

• took low or no tax-free cash because their scheme had generous guaranteed annuity rates
• were in DB schemes but didn’t commute pension for their full tax-free cash entitlement
• took benefits during the four tax years when the LTA was lower than £1.0731M (i.e.2016/17 to 2019/20)
• transferred uncrystallised benefits to a QROPS – LTA will have been used up without any tax-free cash being paid
• took benefits from a scheme including disqualifying pension credits in respect of pension sharing
• are over age 75 and have ‘unused funds’ (i.e. where they haven’t taken benefits yet). These funds will have been tested against, and used up, some of their LTA, so if the standard calculation will deduct 25% of the LTA used from their available LSA, a TTFAC could help. This would also be the case if the second test on drawdown funds at age 75 used up LTA.

An individual will only be able to take full advantage of the TTFAC route if they have sufficient uncrystallised funds to make up for tax-free cash previously ‘lost’, as normally only up to 25% tax free cash can be taken for each future RBCE until the allowance is used up.

Just because one of the above applies to a particular scheme, it doesn’t necessarily mean that the client will get more using this method – the overall tax-free cash position needs to be compared to what’s available via the standard calculation. For example, someone may have taken less than 25% tax-free cash from one scheme, but also took 25% tax-free cash from another scheme when the LTA was much higher, or took scheme-specific tax-free cash of more than 25%. The standard calculation could possibly result in a higher available LSA.

If pension benefits came into payment before 6 April 2006 (i.e. before A-Day) but there were no BCEs from 6 April 2006 to 5 April 2024, it will not be possible to apply for a TTFAC.

Where a BCE had occurred, the deemed tax-free cash from the pre A-Day pension will be valued at 25% of  25 x the annual rate of pension at the time of that first BCE and not the actual amount of the lump sum that was paid.

Applying for a TTFAC

The TTFAC is required before the first RBCE from 6 April 2024, otherwise the standard calculation will apply. So, for clients intending to take benefits soon, it’s crucial to start gathering information as soon as possible to avoid losing out or having to delay taking benefits.

Individuals with registered tax-free cash rights under enhanced or primary protection cannot apply for a TTFAC.

Obtaining the details of tax-free cash taken many years ago could prove difficult – maybe even impossible for some.

The application can be made to any scheme of which the individual is a member. In practice, it’s expected that most individuals will apply to the scheme which will pay the first lump sum after 5 April 2024. If the member has died, the personal legal representatives can apply for the TTFAC.

The scheme administrator will have three months to either supply the TTFAC or explain why they’ve refused to issue it.

Once a TTFAC has been issued, it then supersedes the standard method. The TTFAC cannot be revoked by the member, even if the certified amount is actually lower than the amount calculated under the standard calculation. So it’s important to check before applying!

Exemptions from the 25% rule

For both defined contribution and defined benefit schemes, the normal tax-free cash limit of 25% of the crystallised value of the benefits doesn't always apply, as some individuals may be entitled to either more or less than 25%, for example:

• Scheme specific tax-free cash protection - Before 6 April 2006, occupational pension schemes (including section 32 buyout contracts) could provide more than 25% tax-free cash. Under the pre-6 April 2006 rules, tax-free cash entitlement was based on the member's salary and service with the employer linked to the scheme.
• Enhanced protection with registered tax-free cash – Individuals who registered for enhanced protection could also protect tax-free cash rights if they exceeded £375,000 (25% of the original LTA) on 5 April 2006. This protection was expressed as a percentage of the uncrystallised funds and could be more or less than 25%. This protection is now capped at the tax-free cash entitlement on 5 April 2023.
  
  New contributions can be made after 5 April 2023 without losing this protection, but they will not generate any new tax-free cash entitlement.
• Primary protection with registered tax-free cash - Individuals with primary protection could protect tax-free cash rights if they exceeded £375,000 on 5 April 2006. This could be more or less than 25% of the value of their total uncrystallised benefits.
  
  The registered tax-free cash can be taken from different pension schemes at different times and in different proportions, so long as the total tax-free cash taken from all schemes isn't more than the protected amount - there's no link between the crystallised value of the benefits being taken from a scheme and the tax-free cash paid from that scheme.
• Serious ill-health - Where someone's life expectancy is less than 12 months, their entire uncrystallised pension fund can be paid as a lump sum. If paid before age 75, it's tax-free as long as it's within the individual's available LSDBA. After 75, it can only be paid from unused funds and would be subject to income tax at the member's marginal rate.
• Disqualifying pension credit following divorce - No tax-free cash can be paid where a pension credit is derived from a pension already in payment (as tax-free cash will have already been paid out).
• Guaranteed minimum pension (GMP) - No tax-free cash can be paid from GMP. But where other benefits are crystallised at the same type as the GMP, the maximum tax-free cash is based on the total crystallised value including the GMP. This can mean that the individual's tax-free cash entitlement could be less than 25%.

Defined benefit (DB) schemes

The general rules on the maximum amount of tax-free cash available also applies to DB schemes, although sometime the scheme rules will provide more restricted levels of tax-free cash.

Tax-free cash from DB schemes is commonly provided by one of two methods:

• Commuting pension for tax-free cash - Most private sector DB schemes provide tax-free cash by the member giving up part of their pension for cash.
  
  For example, the scheme rules might stipulate that for every £1 of pension given up the member can take £15 of tax-free cash.
  
  The precise terms will vary from scheme to scheme and depend on market conditions and the member's age when the tax-free cash is paid.
  
  
• Separate lump sum - Some DB schemes (generally public sector schemes) provide a defined level of tax-free cash of, such as 3/80ths of salary for each year of scheme membership. Taking tax-free cash in this way would not reduce the member's pension.
  
  For example, a member retiring with eight years membership on a final salary of £20,000 could receive tax-free cash of £6,000 (calculated as 8 x 3/80 x £20,000).
  
  Some schemes that provide tax-free cash as a separate lump sum will also allow some pension to be commuted to provide additional tax-free cash to take the overall entitlement up to the 25% maximum.

Commuting pension for cash

The amount of tax-free cash available using this method is dependent on the tax-free cash commutation factor used by the scheme. This will vary from scheme to scheme, but it's typically between £12 to £15 of tax-free cash for each £1 of pension given up.

The tax-free cash must not exceed 25% of the benefits crystallised. The value given to crystallised benefits within a DB scheme are 20 x pension, plus the face value of cash.

Maximum tax-free cash (TFC) can be calculated using the following formula:

• Maximum TFC = (20 x pension before commutation) / (3 + 20/CF)

(where CF is the commutation factor applying to the member under the scheme)

Separate lump sum

Some DB schemes, such as many of the older versions of the public sector schemes, provide a defined retirement pension plus a separate amount of tax-free cash. The calculation can vary depending on the scheme but typically benefits are calculated as follows:

• Tax-free cash - 3/80ths of salary for each year of scheme membership
• Pension - 1/80th of salary for each year of scheme membership

When these retirement benefits come into payment, a check must be made to ensure that the tax-free cash paid isn't more than the maximum allowed (normally 25% of the crystallised value of the total benefits).

Maximum tax-free cash can be checked using the following formula:

• Maximum TFC = 25% x [TFC + (20 x actual pension)]

This formula can be simplified to:

• Maximum TFC = 6.666 x actual pension

So long as the defined benefit lump sum is within this limit, it can be paid as tax-free cash. If the lump sum exceeds the limit, the excess will be taxed at the member’s marginal tax rate.

Defined benefit and money purchase benefits in same scheme

In some circumstances it's possible for a scheme member to have both defined benefits and money purchase benefits in the same scheme, for example, where:

• the member has contributed to the money purchase additional voluntary contribution (AVC) section within a DB occupational pension scheme, or
• the scheme is a hybrid occupational pension scheme that provides both defined benefits and money purchase benefits, perhaps for different periods of service or where, for example, a basic defined pension of 1/100th of salary for each year of membership is topped up by a money purchase pot.

Where the scheme member has both DB and money purchase benefits in the same scheme, the member may be able to choose where the tax-free cash is paid from. So if the scheme allows, they could take their tax-free cash from the money purchase pot to avoid commuting the pension from the DB arrangement.

The maximum amount of tax-free cash that can be paid from these schemes is still limited to 25% of the value of the crystallised benefits. However, calculating the crystallised value is more complicated as it will be different depending on whether the tax-free cash is provided by commutation of DB pension, from a money purchase pot, or from a mixture of both.

The following formulae can be used to calculate tax-free cash for schemes with mixed benefits:

1. Tax-free cash paid from money purchase pot only
   
   The formula is:
   
   Maximum TFC = 25% x [MP* + (20 x DB pension)]
   
   (*MP = the money purchase pension pot)
   
   
2. Tax-free cash provided by commutation of DB pension only
   
   The formula is:
   
   Maximum TFC = [MP + (20 x DB pension before commutation)] / (3 + 20/CF*)
   
   (*CF = the commutation factor applying to the member under the scheme)
   
   
3. Tax-free cash from money purchase pot and with top up provided by commutation of DB pension
   
   You can use this formula where 100% of money purchase pot is used to provide tax-free cash and the remaining balance of 25% is provided by commuting some of the DB pension.
   
   The formula is:
   
   Maximum TFC = 20 x [(MP/CF) + (DB pension before commutation)] / (3 + 20/CF)

The tax-free cash rules are complicated where there is a mixture of defined benefits and money purchase benefits within the same pension scheme. However using these formulas can make the calculation relatively straightforward.

The following example illustrates how this could work in practice.