Pension commencement lump sum (tax-free cash)
What is PCLS?
The pension commencement lump sum (PCLS or commonly known as tax-free cash) is the amount of money available ‘tax free’ to the member as a lump sum when they take benefits.
PCLS rules – what do you need to know?
- There’s an upper limit on the amount of pension commencement lump sum available to a member when they take benefits – in most cases this limit is the lower of 25% of the value of pension being put in to payment and 25% of the member’s available lifetime allowance.
- There must be sufficient lifetime allowance remaining to be able to receive the tax-free cash.
- Members’ with pre-6 April 2006 pension rights could be entitled to more than 25% of the standard lifetime allowance.
- To receive a PCLS a member must meet six conditions. If any of these conditions are not met the payment is classed as an unauthorised payment, not a PCLS.
- The approach for calculating tax-free cash is slightly different for defined contribution and defined benefit schemes.
Pension Commencement Lump Sum limit
There’s an upper limit on the amount of pension commencement lump sum (PCLS or more commonly known as tax-free cash/ TFC) available to a member when they take benefits. In broad terms, it’s limited to the lower of 25% of the value of the member’s uncrystallised pension rights and 25% of their available lifetime allowance and there must be sufficient lifetime allowance remaining to be able to receive the tax-free cash.
Finance Act 2004: Para 1, 1A, 1B Schedule 29
Tested at each individual Benefit Crystallisation Event (BCE)
If a member has already used 50% of their LTA, the actual monetary amount of PCLS previously taken, even if this was nil, is not relevant. They cannot take a greater amount of PCLS at their next BCE to compensate.
At their next BCE, the limit becomes the lower of 25% of the uncrystallised funds being taken at that time and 25% of the available LTA (ie 25% of the remaining available 50% of the standard LTA).
For example if you crystallise £100,000 and only take £10,000 of PCLS you will have lost access to £15,000 of PCLS as the remaining £90,000 (either in an annuity or drawdown contract) can only pay taxable income.
Tax-free cash and protection
The differences between the pre A-day maximum benefit rules for occupational scheme membership and the post-6 April 2006 benefit rules (lifetime allowance, etc.) meant many members with pre-6 April 2006 pension rights could have TFC rights greater than the new rule of 25% of the standard lifetime allowance. This is discussed at length in our Tax-free Cash and Protection article.
The following section on standard tax-free cash only applies in relation to those with no tax-free cash protection.
s226 or retirement annuity policies may have had entitlement to TFC in excess of 25% of the fund value before A-day. However, this was lost and reverted to 25% at A-day.
Standard tax-free cash criteria
The six conditions a member must meet to receive a PCLS are:
entitlement to PCLS is connected to an entitlement to a relevant pension
the member has some lifetime allowance available at the time of payment
the lump sum must be paid in the period 6 months before and 12 months after the member becoming entitled to the relevant pension
the lump sum is not paid before the member has reached the normal minimum pension age (there are exceptions to this rule such as protected retirement age or an ill-health condition is satisfied – see the article When can retirement benefits be taken?’. However, any resultant reduction in LTA may impact on PCLS entitlement)
the lump sum is not an excluded lump sum
the amount which can be treated as a PCLS is an amount that does not exceed the permitted maximum.
If any of these conditions are not met, the lump sum is classed as an unauthorised payment, not a PCLS. Additionally, it’s important to note that the tax-free element paid within an uncrystallised funds pension lump sum (UFPLS) is not a PCLS –see our Uncrystallised Funds Pension Lump Sum article
You can find further details from the HMRC Pension Tax Manual.
Here’s a little more detail about these conditions:
For a PCLS to be payable, the member must become entitled to either flexi-access drawdown, a lifetime annuity or a scheme pension (further designation to a capped drawdown plan established before 6 April 2015 will also generate a further PCLS in respect of the newly crystallised funds). Entitlement arises when the member has an 'actual right' to receive a pension (although they don’t necessarily need to actually draw that income).
In order to receive a pension commencement lump sum, the member must have sufficient lifetime allowance available. The scheme administrator must satisfy themselves that this is the case. This is calculated by the formula:
(CSLA - AAC) / 4
…Where CSLA - is the current standard lifetime allowance and AAC is the total of the amounts previously crystallised.
CSLA should be used unless the member is entitled to protection from the lifetime allowance – please see our Tax-free Cash and Protection article for further details.
Any lump sums paid before A-day are not normally included in AAC (the exception being where a lump sum is paid before 6 April 2006, and on or after 27 July 2004 the member chose to defer the pension to which it relates).
AAC includes any pre-commencement (ie pre-6 April 2006) pension rights. The Taxation of Pension Schemes (Transitional Provisions) Order 2006 confirms that this includes the capitalised value of pre commencement pension rights (using a factor of 25). By using the factor of 25, the amount of any lump sum available from the pre commencement pension is deemed to have been taken in relation to that relevant pension – regardless of whether it was taken or not.
What happens without sufficient lifetime allowance?
Where the member doesn’t have sufficient lifetime allowance remaining to take their full tax-free cash entitlement under the rules of the scheme, the PCLS is limited to the permitted maximum. However, the balance may be paid as a lifetime allowance excess lump sum, which would be taxed (deducted by the scheme administrator) at 55%. The alternative to this would be designating it as income, suffering the 25% LTA charge and taking the money as income taxed at marginal rates.
Finance Act 2004 636A (5)
This scenario shouldn’t be confused with a member within their LTA, who, perhaps in error takes a lump sum in excess of their PCLS entitlement. The excess could be regarded as an unauthorised payment, unless the overpaid portion meets the conditions within regulations 17 or 18 of The Registered Pension Schemes (Authorised Payments) Regulations 2009. If it can be treated as an authorised payment, this is a separate benefit crystallisation event (BCE 9) from the PCLS payment.
Timing of lump sum payments
The lump sum must be paid in the time between 6 months before and 12 months after the member becomes entitled to the relevant pension. In practice, the lump sum is normally paid once the scheme administrator has received the member's signed acceptance forms and at the same time as the pension is set up.
SI 2006/135 The Registered Pension Schemes (Meaning of Pension Commencement Lump Sum) Regulations 2006 as amended by SI 2007/3533
PCLS can’t be paid unless the member has reached the normal minimum pension age, satisfies the ill-health criteria, or they have a protected early retirement age.
There are two main types of excluded lump sum:
- one that is based on an overinflated bridging pension. As the amount of PCLS payable is based on the amount of pension payable, HMRC recognise that a scheme may provide the member with a pension for a limited period (bridging pension), artificially increasing the amount payable in order to increase the amount of PCLS payable. Any lump sum paid in these circumstances does not qualify as a PCLS payment.
- it is not possible to pay a lump sum from a disqualifying pension credit (pension sharing transfer on divorce) that originated from crystallised rights.
Paragraph 1(1)(f) and (4) Schedule 29 Finance Act 2004
The total tax-free lump sum paid to an individual from all pension arrangements can’t exceed 25% of the standard lifetime allowance (except where the lump sum is protected).
Where a lifetime allowance charge has been overpaid (or paid erroneously), a further pension commencement lump sum may be paid in respect of that charge. The lump sum must be paid within 12 months of the day the scheme receives the refund from HMRC.
Paragraph 1(6) Schedule 29 Finance Act 2004
How to calculate the amount of tax-free cash
This is slightly different for different types of pension. For defined contribution schemes it’s less complex and is 25% x value of the fund.
For defined benefit schemes the calculation is 25% x (tax-free cash + residual value), but a commutation factor is needed.
Max cash = (20 x commutation factor x yearly scheme pension before commutation)
20 + (3 x commutation factor)
You may recognise the formula above expressed as
Max cash = Pre-commutation pension x Commutation factor
[1+(0.15 x Commutation factor)]
The second formula is used within many exam study texts. It’s important to note this formula gives exactly the same answer as the previous (HMRC preferred) method.
Paragraph 1 to 3 Schedule 29 Finance Act 2004
ARTICLE by The Technical Team
Tax-free cash and protection
Information on tax-free cash (TFC) and how it can be protected; the type of Lifetime Allowance protection held can also impact the calculation of the maximum TFC.
ARTICLE by The Technical Team
Uncrystallised funds pension lump sum (UFPLS)
Information on uncrystallised funds pension lump sum (UFPLS); what it is, why it was introduced and how it is taxed.
ARTICLE by The Technical Team
Pension recycling is where a pension lump sum, or pension income, is recycled by reinvesting the income or lump sum into pension as a tax relievable contribution.