Pension triviality - 'small' pension pots

Small pots and defined benefit trivial commutations

What is a pension small pot payment?

Due the nature of working life many of us move employer several times and as a result we can leave behind small pension pots. If you have small pensions, you may be able to take them as cash lump sums - up to three small pots of £10,000 each from non-occupational pension schemes and an unlimited number from occupational pension schemes, subject to certain rules.

Small pots - so what do you need to know?

1. A maximum of three small, non-occupational pensions can be commuted under small pot payments.

2. There is no limit to the number of occupational pensions that can be commuted under small pot rules.

3. A small pot payment (properly called ‘small lump sum’) can be made from any arrangement, whether the rights are uncrystallised or comprise a pension in payment, irrespective of the overall value of the individual's pension's worth. Up to three small non-occupational pensions (personal pension plans etc.) can be commuted under small pots payments, but there’s no limit on the number of occupational pensions that can be taken under small pots. To allow the payment of small pot commutation, the following conditions need to be fulfilled:

4. The member has reached the minimum retirement age of 55, or satisfies the definition for ill-health early retirement or has a protected early pension age each payment must not exceed £10,000 at the time it’s paid to the member

5. For non-occupational pension schemes, the payment must extinguish all member benefit entitlement under the arrangement

6. For occupational or public service pension schemes, the payment must extinguish the member’s entitlement to benefits under the paying scheme, in respect of non-occupational pensions (personal pensions etc.), there’s a maximum of three small pot payments are permitted. A full list of the conditions is in the Pensions Tax Manual (PTM063700) covering;

   1. Payments under occupational or public service pension schemes

   2. Payments under larger occupational or public service pension schemes

   3. Payments under a scheme that is not an occupational or public service pension scheme

Small pots from non-occupational pension schemes are about arrangements, not schemes

‘Small pots’ applies at arrangement level rather than scheme level. So the payments can be made from two or three separate registered pension schemes or from the same scheme where the payments are made from two or three different arrangements under that scheme.

Effect on entitlement to benefits

Small pot payments extinguish the member’s entitlement to benefits under the arrangement from which the payment is made, but not necessarily their entitlement under the scheme as a whole. A member can take a small lump sum even though they may still have an entitlement to benefits under another arrangement in that scheme.

Managing a large number of arrangements

For example 100 arrangements under the same registered pension scheme, where each arrangement contains well under the commutation limit under this regulation. Subject to what the scheme rules allow, these funds may be consolidated either by merging arrangements into a smaller number of arrangements or by a transfer of funds between multiple arrangements. This allows the maximum small pot to be taken from either one or each of two or three arrangements under the scheme. A ‘reshaping’ of existing arrangements (either by merging multiple arrangements or internal transfers of funds between multiple arrangements in the same scheme) won’t involve the setting up of a new arrangement. This avoids any potential consequences for members who have valid enhanced protection, fixed protection, fixed protection 2014 or fixed protection 2016.

Funds in excess of the commutation limit

If a member has funds in excess of the limit in an existing single arrangement, some of which are then moved into arrangements set up to allow a member to take one, two or three small lump sum payments under Regulation 11A, this will entail the setting up of one or more new arrangements. This could potentially have consequences if the member has valid enhanced protection or any of the fixed protections (i.e. the protection would be lost).

Please note: small pots don’t trigger the money purchase annual allowance (MPAA). 

Crystallised and uncrystallised benefit rights

Where the payment represents uncrystallised benefit rights, 25% of the payment is free of income tax, and the balance of the payment is chargeable to income tax as pension income. If the payment represents crystallised rights, all of the payment is chargeable to income tax as pension income. Where the payment represents a mixture of both uncrystallised and crystallised benefit rights, only 25% of the part of the payment relating to the uncrystallised rights can be paid free of income tax.

What is trivial commutation?

Trivial commutation is where a defined benefit pension member may commute one or more pension arrangements as long as they comply with the following:

1. the member has reached the minimum retirement age of 55, or satisfies the definition for ill-health early retirement or has a protected early pension age

2. the lump sum extinguishes the member’s entitlement to defined benefits under the registered pension scheme making the payment

3. all commutations must take place within a 12-month period from the date of the first trivial commutation payment. Any commuted lump sum paid after the 12-month period has ended won’t qualify as a trivial commutation lump sum

4. the value of all members’ rights should not exceed £30,000 on the nominated date (the nominated date can be any date within 3 months of the start of the commutation period). The £30,000 value is for all pensions, so if a client has a DB scheme valued at £29,000 and a Stakeholder Pension worth £2,000 on the nominated date then commuting the DB scheme will not be possible.

5. the member hasn’t been paid a trivial commutation lump sum previously (from any registered pension scheme), except any earlier payment within the commutation period (a trivial commutation that occurred before 6 April 2006 doesn’t count)

6. the lump sum is paid when the member has some available lifetime allowance.

If the member hasn’t previously drawn or become entitled to any other benefits under the registered pension scheme before the trivial commutation lump sum is paid, 75% of the lump sum paid is treated as taxable pension income for the tax year the payment is made, accountable through PAYE. The 25% deduction is given to reflect that, if the trivial commutation lump sum wasn’t paid and normal benefit rules applied, the member would (generally) be entitled to a tax-free pension commencement lump sum, representing 25% of the capital value of the benefits coming into payment. No extra deduction is given where the member is entitled to a pension commencement lump sum of more than 25%, due to the transitional protection of such an entitlement held before 6 April 2006.

Where a pension in payment is being commuted, or the member has previously drawn (or become entitled to) any other benefit from the scheme, but still has uncrystallised rights held in any arrangement under the scheme, 25% of the value of the uncrystallised rights may be paid tax-free. The remaining part of the payment is taxed as pension income for the tax year the lump sum payment is made. Again, this taxable income is accountable through PAYE.

Since April 2015, trivial commutation of all pension benefits has only been relevant to defined benefit pension schemes. Historically, it was also used for defined contribution schemes. However, the introduction of pensions flexibility for DC schemes after April 2015 removed the need for this option, as all DC benefits can now be accessed as lump sum (regardless of the amount).

Commutation of DB lump sum death benefit

If, on the death of a member the capital value of the following pensions is under £30,000 per scheme, a commutation lump sum death benefit can be paid instead of the ongoing pension benefit:

1. dependant / nominee / joint life pension

2. guaranteed annuity / scheme pension guarantees.

The commutation lump sum death benefit will be subject to marginal rate income tax in the hands of the recipient.

Pension guide

Pension information: guide to the basic facts.

You might have one or more different types of pension. Understanding which you have is important because it affects the decisions you need to make as you approach retirement.

• What type of pension do I have?

• Your State Pension choices

• Your pension choices if you have a defined benefit pension

• Your pension choices if you have a defined contribution pension

What type of pension do I have?

What is a pension pot?

‘Pension pot’ refers to the savings you build up in a certain type of pension known as a ‘defined contribution’ pension scheme. You and your employer (if you are employed) pay into the scheme and this builds up a ‘pot’ of money over time, which you can use to give yourself an income when you want to cut down on how much you work, or stop working altogether. It includes workplace, personal and stakeholder pension schemes.

There are three main types of pension:

• the State Pension

• defined benefit pensions, and

• defined contribution pensions

State Pension

Most people get some State Pension. It’s paid by the government and is a secure income for life which increases by at least the rate of inflation each year.

You build up your entitlement to the State Pension by making National Insurance contributions during your working life.

In some cases, you can do this even when you’re not working, such as when you’re bringing up children or claiming certain benefits.

From April 2016 a new flat-rate State Pension was introduced. For the current tax year 2019-20 the full new State Pension is only £168.60 per week.

However, you might be entitled to more than this if you have built up entitlement to ‘additional state pension’ under the old pre-April 2016 system – or less than this if you were ‘contracted out’ of the additional state pension.

To be eligible for the full State Pension you will need 35 years NI record. You’ll usually need at least 10 qualifying years on your National Insurance record to qualify.

Defined benefit pension

You’re most likely to have a defined benefit (DB) pension if you work in the public sector or for a large company. This is a salary-related pension which pays out a secure income for life and increases each year. The pension you get is based on how long you’ve been a part of the scheme and how much you earn.

You might have a final salary scheme where your pension is based on your pay when you retire or leave the scheme, or alternatively a career-average scheme where your pension is based on the average of your pay while you were a member of the scheme.

Defined contribution pension

With this type of scheme, you build up a pension pot which you can draw an income from when you cut down or stop working. But you must be aged at least 55 before you can start to take money out. With this type of pension scheme, you can usually withdraw at least 25 per cent (a quarter) of your pot tax-free.

The amount that builds up depends on:

• the level of charges you pay

• how well your investment performs, and

• how much you and your employer (if you are employed) pay into the scheme

Defined contribution (DC) pensions include workplace, personal and stakeholder pension schemes.

Your State Pension choices

You won’t get your State Pension automatically – you have to claim it. You should get a letter no later than two months before you reach State Pension age, telling you what to do.

You can also defer taking it. If you want to wait to claim your pension, you don’t need to do anything. Your pension will automatically be deferred until you claim it and will increase by 1% for every nine weeks you defer. This works out at just under 5.8% for every full year.

The extra amount is paid with your regular State Pension payment when you finally take it.

Find out your State Pension age at GOV.UK

Your pension choices if you have a defined benefit pension

Most defined benefit pension schemes have a normal retirement age of 65.

If your scheme allows, you might be able to take your pension earlier but this will reduce the pension you get quite considerably. (Typically 5% per annum)

When you take your pension you usually have the option of taking some of it as a tax-free cash sum.

How much you can take will vary depending on your scheme rules, but often you can take roughly up to a quarter of the value of your pension benefits like this.

Reducing the amount of tax-free cash you take might increase the amount of income you receive.

It is possible to transfer your defined benefit pension to a defined contribution pension which would then allow you to access your pension more flexibly.

However, consider this option very carefully as you might be giving up very valuable benefits.

Before going ahead with a transfer from this type of scheme speak to a regulated financial adviser.

Your pension choices if you have a defined contribution pension

Once you reach 55 you have complete freedom over what to do with your pension pot.

However, the longer you leave your pot to continue building up, the more money you will have to live on in retirement.

To understand the choices for using your pension pot, use could use Pension Wise – the free and impartial service backed by government or if you are still unsure of the best option for you, consider taking regulated financial advice.

Source: pensions advisory service

WINN-BROWN & CO.NOVEMBER 2, 2015

Money purchase annual allowance (MPAA)

The MPAA trap

This little known tax rules mean that pension savers could see their ability to save into a pension slashed by up to 90% if they draw money from the ‘wrong’ pension pot, according to new analysis by mutual insurer Royal London. 

Since the introduction of ‘pension freedoms’ in April 2015, savers aged 55 or above have been able to take money out of their pensions in ‘chunks’ rather than turn the whole pension pot into an income for life by buying an annuity. To prevent people from repeatedly taking money out, benefiting from tax free cash, and putting money back in again with the benefit of tax relief, HMRC introduced a limit on the amount people could put back in to pensions once they had started drawing taxable cash. 

This limit is known as the Money Purchase Annual Allowance (MPAA) and was originally set at £10,000 per year, but has since been cut to £4,000 per year. This compares with the standard annual allowance of £40,000. 

In general, someone taking money out of a ‘pot of money’ or ‘Defined Contribution’ pension is affected by the MPAA if they draw money out beyond the 25% tax-free lump sum. 

But there is a little known exception to this rule. Those who take everything out of a ‘trivially’ small pension pot under £10,000 do *not* trigger the MPAA. 

If an individual has two pensions and wants to withdraw less than £10,000, they should think seriously about cashing in a small pot in full rather than taking a partial withdrawal from a larger pot, as this avoids triggering the MPAA. As a result, they retain the ability to put up to £40,000 into a pension each year in future, rather than having it slashed to £4,000. 

Consider, for example, someone with two pension pots, one worth £4,000 and one worth £20,000. Suppose that they want to withdraw £9,000 (before tax). If they cash in the £4,000 pot in full and take just the 25% tax free lump sum out of the larger pot, they will not trigger the MPAA. But if they take the full £9,000 from the larger pot they will trigger the MPAA which will reduce by 90% their annual allowance going forward. 

Commenting, Steve Webb, Director of Policy at Royal London said: 

“Last year, over half a million people aged 55 or over made flexible withdrawals from their pension, and many of these withdrawals will have been for amounts under £10,000. If they emptied out a small pot then this will have had no impact on their future ability to save into a pension. But if, by mistake, they took the same amount as a partial withdrawal from a bigger pot, they risk triggering stringent HMRC limits on future pension saving. Those with more than one pension pot should consider very carefully the order in which they access these funds, especially if they may want to contribute into a pension in future”. 

Source: Royal London

Pension drawdown costs.

The charges and fees on pensions with a drawdown facility can vary considerably depending on which provider you choose.

Under pension drawdown (also called “income drawdown”) you are permitted to take money from your pension funds as and when you want to. At the same time you may leave the remainder invested whilst still in retirement.

Here are the sorts of costs you would typically pay when taking advice in setting up a drawdown pension, these fees can vary depending on your situation. We can break these costs down as follows:

• How much does a drawdown pension cost?

• Choosing the right pension drawdown product for you

• Speak to an income drawdown expert

How much does a pension drawdown cost?

The costs involved in pension drawdown are individual/pension specific.

All providers will work to different terms and the associated costs could have a big impact on how much you end up paying. Typical pension drawdown charges include (but are not limited to):

• Set-Up Fees - Typically a standard fee

• Administration Fees - Typically a standard fee but some lenders may calculate costs based on how much you have in your pension pot.

• Fee(s) on withdrawal(s) of the 25% tax-free sum - Some providers don’t charge for any withdrawals of the 25% tax-free sum, others may charge a fee (set or variable) per withdrawal

• Fee(s) on additional withdrawal(s) over  25% tax-free sum - Some providers don’t charge for any withdrawals of the 25% tax-free sum, others may charge a fee (set or variable) per withdrawal

• Income Tax charged on each additional withdrawal - Withdrawals outside the 25% will be added to any other income you have which could impact how much Income Tax you pay

• Fees for ongoing pension drawdown management - Some providers will charge a set fee, but many will charge a percentage of your pension funds    

• Transfer fee / exit charges - Typically a standard fee

You would be advised to carry out a pension charges comparison to find out which income drawdown product is best suited to you before you commit to a product.

Choosing the right pension drawdown product.

The first 25% of your pension is tax-free, irrespective of whether your fund is £40,000 or £400,000. After that HMRC consider the remaining 75% to be earned income and therefore taxable. The amount you take after the initial 25% could potentially limit how much you can pay into a pension in the future.

You should be aware that by taking any income outside of your 25% tax-free allowance could potentially put you in danger of being pushed into a higher tax bracket, as these funds will be added to any other taxable income you have.

You also should be aware of the lifetime allowance as further tax may also apply if the value of your pension savings exceeds £1,030,000 when you access the funds.

Speak to an income drawdown expert

We can arrange a free pension review for you today.

Income drawdown

You can get an income from your pension pot that’s adjustable. This means you get a regular income but can change it or take cash sums if you need to. 

● You get 25% of your pot as a single, tax-free cash sum

● The other 75% is invested to give you a regular but taxable income 

● You can adjust, to suit your specific needs, the income you take and when you take it

This option is also known as ‘flexi-access drawdown’. 

You will need to be involved in choosing and managing your investments, which is why previous investment experience would be beneficial. The value of your pot can go up or down. 

As not all pension providers offer this option, you can transfer your pot to another provider but you will probably have to pay a fee. 

Taxation 

The income you get from the investment is taxable. Your provider will pay you the income net of tax. 

You pay tax when you take money from your pot. This is because when you’re paying into your pension you get tax relief on your contributions. 

Example 

You have a pot of £100,000 and take a tax-free lump sum of £25,000. This leaves you with £75,000 to invest. You get an income of £3,750 a year from your investment. If you pay 20% tax you’ll get £3,000. 

If you take the 25% tax-free lump sum, you must get an adjustable income with the rest or use one of the other options . 

You can move your pot gradually – you don’t have to move it all at once. Each time you move a sum, 25% is tax free. 

If you choose this option, you can leave your money to someone when you die but they may have to pay tax on it, depending on a number of factors.

How adjustable income works 

Different investments have different risks. You pick the investments that match your attitude to risk and get a retirement income from them. You need to think about how much you take out every year and how long your money needs to last . 

A financial adviser can help you create an investment plan for your money. They can advise you on how much you can take out to make the money last as long as possible. They’ll charge you a fee for this. 

Your provider is likely to charge you fees for managing your investments and whenever you get a payment. 

If your provider collapses you’ll be covered by the Financial Services Compensation Scheme . 

Continue to pay in 

If you have more than one pension pot, you can take an adjustable income from one and continue to pay into others. However, you may have to pay tax on contributions over £4,000 a year (known as the ‘money purchase annual allowance’ (MPAA) ). 

This includes your tax relief of 20%. For example, to get a contribution of £3,000 you would only have to pay in £2,400. 

You may still be able to pay into the pot you take your adjustable income from but you won’t get tax relief on these payments. 

Financial advice 

If you’re interested in this option you might want to get financial advice first. A financial adviser can help you to compare adjustable income products and work out which is best for you. 

Scams 

Beware of pension scams contacting you unexpectedly about an investment or business opportunity that you’ve not spoken to them about before. You could lose all your money and face tax of up to 55% and extra fees. Please see out blog on scams.