Pensions: Turning your small pension into cash

Two pensioners
Image caption Increasing numbers of people will be faced with the option of cashing in small pension funds

Forthcoming changes to the taxation of pensions in April 2012 will not just affect high earners.

They will affect those for whom the opportunity exists to cash in the whole of a small pension worth less than £18,000.

It is estimated there could be up to 20,000 individuals who take this option annually.

However many people in government departments and in the pensions and financial advisory industry often do not know how the rules work and how to apply them, meaning extra cost for the low income pensioner.

The essentials

There are important differences in the rules depending on whether your pension savings amount to more or less than £18,000.

If you have got more than £18,000, then when a pension commences, it is possible to pay out up to 25% of the capital value of the pension tax-free.

Under present rules, the maximum the majority of us can have in one or more tax-favoured pensions (known as the Lifetime Allowance or LTA) is £1.8 million.

This will reduce to £1.5 million from April 2012.

This means that, for those that have saved the maximum, it is possible to get a tax-free lump sum - or aggregate sums if there is more than one pension pot - of up to £450,000 (reducing to £375,000 from 2012).

This part lump sum option is referred to as "commutation" and the majority of new pensioners take advantage of it.

The annual pension is reduced proportionately, of course.

The important point is that the law does not allow for the whole pot to be commuted tax-free and, if the rules are breached, a penalty rate of tax (between 40% and 55%) is applied to the excess.

Small pension "pots"

There is an exception however, which allows the whole capital value to be paid out after age 60.

That is where the aggregate capital values of an individual's pension savings are considered to be trivial - defined currently as 1% or less of the LTA, or £18,000.

Thus we have what is known as trivial commutation - the taking of the whole of a very small pension as a single lump sum.

The rules say that, if a trivial commutation lump sum payment is made, then, provided the right to the pension has not yet arisen (i.e. provided the pension isn't in payment or hasn't been voluntarily deferred by the pensioner), 25% of the payment is tax-free and the rest taxed as pension income.

If the lump sum is made after the right to the pension has arisen, then it is all taxed as pension income.

What goes wrong

At the point of payment, the pension provider has to apply PAYE to the payment, treating it as if it was a single weekly or monthly salary payment.

Image caption Larry Darby, Low Incomes Tax Reform Group

This means only part of the annual tax allowances and tax rates are applied to the payment.

This frequently means that too much tax is initially deducted.

It is possible to claim a refund of any excess tax before the end of the tax year, using a special form (P53) provided by HM Revenue & Customs (HMRC).

To support that refund, the pension provider must provide the recipient with a form P45.

The problem is that, quite often, the pension provider (particularly if it is one of the smaller companies) does not know they are supposed to do this.

So the pensioner can be left with no evidence of the tax deducted to make the claim.

HMRC staff are frequently unaware of the mechanism for making in-year claims for repayment of tax.

As a result, getting the money back can take some considerable time.

There is the additional problem that far too often forms sent to HMRC become lost, creating delay by forcing the taxpayer to try to get new forms issued.

More than one

In many cases, individuals have more than one pension pot which, when added together, come to less than the £18,000 limit.

It is possible within the rules to take a trivial commutation lump sum payment from more than one pension.

This can be done if the total, together with the capital value of other pensions which are not commuted, come to less than the limit.

The rules say all such commutations have to be made in a 12-month period starting with the first commutation.

This is quite restrictive, and could be argued to be unfair when the same rule doesn't apply to those with larger pension pots.

However, it does allow some flexibility for keeping the overall tax rate down.


Assume an individual can commute two pensions providing lump sums of £9,000 each.

If both are taken in the same tax year - for instance the year in which the individual retires from employment - then the rate of tax applicable could be higher than if one payment was deferred until the next tax year, when the individual will be on pension and therefore probably receiving a lower income.

Far too often the possibility of choosing the date on which to receive the payment is not brought to the individual's attention.

In particular, on occasions where financial advisers are involved, individuals are often encouraged to cash in as soon as possible without thought to the possible extra tax cost.

Automatic enrolment

Another change coming in in April 2012 is the requirement for employers to automatically enrol all staff above a certain age into pension schemes.

This could see a substantial increase in the number of individuals with small pension "pots" which may be cashed in.

On the other hand, with the reduction in the LTA from April 2012, there was a danger that size of pension pot available for trivial commutation would be cut too.

But the government has recognised this and is planning in this year's finance bill to keep the limit at £18,000 with the possibility to increase it in the future.

With annuity rates declining, and so the amount of pension you can get for £18,000 reducing over time, this is a welcome move.

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