Lump sums explained

Whether you are a member of a defined contribution pension plan or a defined benefit scheme, you will have the opportunity to extract a lump sum from your pension.

Most people are aware that they can take a tax-free lump sum from their pension, but how does it work? And are there other ways that you can extract a cash sum in retirement? There are many strategies you can take in extracting a lump sum and a TPO adviser can help you explore them. 

What lump sum options are available?

The options available to you depend on the type of pension you have.

A defined contribution pension is one where you build up a pot using your personal contributions and those from your employer, plus tax relief and investment growth.

A defined benefit pension is one where you receive a guaranteed income based on such factors as your salary and the length of service with your employer.

The options available to members of defined contribution pensions are:

• Pension Commencement Lump Sum (PCLS), also commonly known as tax free lump sum.
• Uncrystallised Funds Pension Lump Sum (UFPLS).
• Small-pot lump sum.

The options available to members of defined benefit pensions are:

• Pension Commencement Lump Sum (PCLS), also commonly known as tax free lump sum.
• Trivial commutation lump sum.
• Small-pot lump sum.

How long does it take to receive lump sum pensions?

Typically, lump sum payments taken from a defined contribution scheme can take up to ten working days from the initial request for the funds to be paid into your bank account. The timescale for lump sum payments from a defined benefit scheme will depend on the specific scheme and you should seek clarity from the trustees.

The decision as to whether to take a pension commencement lump sum has to be made at the point you access your pension fund, although with defined contribution pensions this can be done in stages.

In normal circumstances, you cannot access your pension before the minimum pension age.

The minimum age from which people can access their pension savings is currently 55 and set to increase to 57 in 2028. 

Your defined benefit pension will have a normal retirement age, this is usually the age at which you stop accruing further benefits and are entitled to receive your pension and PCLS.

Depending on the rules of your scheme, you may be able to take your pension and PCLS before the normal retirement age, but this can reduce the amount you receive. 

There are special rules which also allow you to take your entire pension fund as a lump sum if you are in serious ill health, by this we mean with a reduced life expectancy.

If you find yourself in this situation and would like to know more please call us on 0333 325 9065.  

Taking a PCLS from your defined contribution pension

If you have a defined contribution pension, you can normally take up to 25% of the plan value as a tax-free lump sum known as a PCLS. 

You have the option to take all of your PCLS at once, or in stages.

Each time you access an element of your pension fund (known as crystallising), you can receive 25% of the crystallised amount as a PCLS, with the remaining 75% used to provide you with an income through either a one-off taxable lump sum, income drawdown or a lifetime annuity.

Taking a PCLS from your defined benefit pension

If you have a defined benefit pension, you can also normally take up to 25% of the value of your benefits as a PCLS.

However, the method by which the value of your PCLS is determined, and the effect this can have on the income you receive from the scheme, is slightly more complex.

The value of your defined benefit pension is determined by multiplying your annual pension from the scheme by 20. The maximum PCLS is 25% of this value.

Where your PCLS is achieved by giving up some of your pension, the rules of the scheme will specify the commutation factor which is used to determine how much your annual income will reduce by as a result of taking the PCLS.

For example, a commutation factor of 10:1 means that for every £10 of PCLS taken, the annual pension income will reduce by £1.

Not all defined benefit pensions work in this way. In some schemes, your PCLS will accrue separately from your pension income.

For example, you may be entitled to an income of 1/80th of your salary for each year of service and a PCLS of 3/80ths of your salary for each year of service. This means that your guaranteed pension income does not reduce as a result of taking a PCLS.

This method is less common, but it is important to understand which method applies to your pension to avoid any unwelcome surprises. 

What is the maximum PCLS I can take?

There is a limit on the total amount of PCLS you can receive. In normal circumstances, each time you crystallise some benefits the limit is the lower of:

• 25% of the value of the pension benefits being crystallised, and
• 25% of your available Lump Sum Allowance - subject to an overall monetary limit of £268,275 for most people.

What is an uncrystallised funds pension lump sum (UFPLS)?

This gives you the opportunity to withdraw a one-off or series of lump sums from your defined contribution pension without the need to move funds into a drawdown plan.

Provided you have sufficient Lump Sum Allowance remaining, 25% OF THE UFPLS will be paid tax free , with the remaining 75% subject to income tax at your marginal rate of tax. If you do not have enough Lump Sum Allowance remaining to receive 25% of your UFPLS tax free, you can still take a lump sum withdrawal but more of the payment you receive will be subject to income tax. 

An uncrystallised funds pension lump sum (UFPLS) can only be paid from uncrystallised pension funds, that is those that you have not already accessed.

As the option to take an UFPLS was only introduced in 2015, not all pension plans offer the flexibility for you to take one. Where this is the case, it would be necessary to transfer your pension to an alternative plan.

Can I still make pension contributions if I take an UFPLS?

Once you have taken an UFPLS from any pension arrangement you will have a reduced maximum annual allowance of £10,000 in respect of your (and your employer’s if applicable) future contributions to money purchase pensions, this is known as the money purchase annual allowance or MPAA. 

What is a trivial commutation lump sum?

The trivial commutation lump sum rules allow you to convert your entitlement under defined benefit pensions to a one-off lump sum payment. 
You can take a trivial commutation lump sum from uncrystallised pensions (those that are yet to be accessed) and crystallised pensions (those that you have already accessed). 

There are set criteria that you need to meet in order to take a trivial commutation lump sum.

• The total value of your pension rights from all sources must be £30,000 or less.
• The payment must eliminate your defined benefit pension rights under the scheme.

If the lump sum is paid from an uncrystallised pension, a maximum tax free lump sum of 25% may be taken, with the balance taxable at your marginal rate of income tax. If it is paid from crystallised funds, the full balance is taxable.

If you have more than one defined benefit pension, there is a time limit on when you are able to take a trivial commutation lump sum, this is known as the commutation period. The commutation period starts when you take your first lump sum and lasts for 12 months.

Once this period has ended, no further defined benefits can be taken as trivial commutation lump sums.

What is a small pot lump sum?

A small pot lump sum is a simple way to fully encash your lower value pension plans, as the rules only apply to plans (defined benefit or defined contribution) with a fund value of £10,000 or less.

The criteria for taking a small pots lump sum is:

• The value of the specific pension plan must be £10,000 or less.
• The payment must eliminate your pension rights under that specific scheme or plan.

Taking a small pot payment will not use up any of your Lump Sum Allowance. 

There is a limit on the amount of small pots you can take from personal pensions and other non-occupational pensions.

A maximum of three personal pension plans (i.e. those not arranged by your current or previous employer) can be taken as a small pot lump sum, but there is no limit on the amount of occupational pensions you can take (i.e. those arranged by your current or previous employer).

The income tax treatment of a small pot lump sum is the same as that of a trivial commutation lump sum. 

Should I take a lump sum?

You may decide that taking a lump sum is appropriate for you if you wish to:

• Repay loans or debts 
• Make home improvements 
• Make a large purchase 
• Make gifts to family members
• Boost your emergency cash reserves

However, with all of the options available to you it is not always clear which is the best way to withdraw a cash sum from your pension, or whether it is in fact the right thing to do. The rules around tax on pension withdrawal can also add further confusion to the process of selecting an appropriate course of action.

How can we help?

Deciding on the best way to access your retirement savings is an important decision.

By creating a tailored retirement plan, we can help you to make the right decisions in relation to your pension savings and guide you through a comfortable retirement.  

The decision should be viewed in conjunction with your current circumstances and tax position, as well your future goals and aspirations. If you would like to know more about how we can help with your retirement speak to an adviser for more information.

Please note: Pensions are a long term investment and any income derived from them is not guaranteed, the value of these investments can go down as well as up and you may not get back what you originally invested. The FCA does not regulate tax advice.