Contents

• When tax-free cash can be paid 
• How tax-free cash is calculated 
• Tax-free cash under defined benefit schemes  
• Tax-free cash and AVCs  
• Pension Commencement excess lump sum 
• Transitional Protections 
• Scheme specific tax-free cash
• Stand-alone lump sums
• Where tax-free cash can be lower than 25%

 

When tax-free cash can be paid

Tax-free cash can be paid once the individual reaches the normal minimum retirement age (currently 55 but increasing to age 57 on 6 April 2028). It can also be paid earlier where a member meets the requirements for an ill-health pension or has an entitlement to a protected low retirement age. 

Tax-free cash is technically known as a pension commencement lump sum. This is because it can only be paid in connection with an individual’s entitlement to a “relevant pension” benefit (i.e. a scheme pension, lifetime annuity or drawdown pension) under the same registered pension scheme.   

Although funds have to be designated to drawdown for the associated tax-free cash to be paid, there is no requirement to take any drawdown income. Therefore, where an individual only requires tax-free cash they can achieve this in a defined contribution scheme via the drawdown option. 

Tax-free cash must be paid within a period beginning six months before, and ending 12 months after, a member becomes entitled to a relevant pension. If these conditions are not met then any tax-free cash paid becomes an unauthorised payment.

Tax-free cash can only be paid provided the member has available lump sum allowance (LSA) and lump sum and death benefit allowance (LSDBA) at the time of payment. Taking tax-free lump sums from 6 April 2024 along with any benefits crystallised before 6 April 2024, will reduce the available allowances. More information on this is available on our Lump Sum Allowance and Lump Sum and Death Benefit Allowance article.

It’s possible to defer taking tax-free cash beyond the member’s 75th birthday. However, there may be some restrictions on how much tax-free cash can be taken after age 75. Where someone turned 75 before 6 April 2024 the pension will have been valued against the lifetime allowance as either a BCE 5, 5A or 5B. The standard approach to working out the available LSA will include BCE 5, 5A or 5B if the client has taken any tax-free cash between age 75 and 5 April 2024. If no tax-free cash has been taken between age 75 and 5 April 2024, then BCE 5, 5A and 5B won’t be included in the standard calculation. 

Due to this, some clients may find their available LSA is restricted as a result of benefits tested at age 75. Such clients may therefore need to apply for a transitional tax-free amount certificate to maximise the amount of tax-free cash they can take. 
 

How tax-free cash is calculated

The maximum allowable tax-free cash that can be taken from any pension is the lesser of: 

• 25% of the value of their pension rights
• the available LSA
• the available LSDBA

For most people the standard LSA will be £268,275 and therefore is the maximum most clients will be able to take as tax-free lump sums. 

We include details of the different LSA for transitional protections further in the article. The LSDBA is only likely to be a factor when someone has taken serious ill health lump sums. 

In order to work out the available LSA remaining, any previously used amounts must be deducted from the starting amount. This includes:

• the non-taxable elements of any relevant lump sums paid after 5 April 2024.
• 25% of the lifetime allowance previously used amount using the standard calculation, or, the lump sum transitional tax-free amount shown on a transitional tax-free amount certificate.
• 25% of the amount of any deemed BCE for benefits in payment before 6 April 2006. 

For defined contribution schemes this is generally straightforward.  

 

Tax-Free Cash under a Defined benefit scheme

A member of a defined benefit scheme will be provided with a scheme pension. The tax-free cash is calculated as 25% of the value of their benefits, although some scheme rules may be more restrictive. Generally, the pension benefits must be commuted or given up to provide the tax-free cash. However, some schemes may provide tax free cash as a separate lump sum. 
 

• Commuting for tax-free cash 

When commuting the pension for tax-free cash the following formula can be used to determine the maximum tax-free cash: 

Pension x commutation factor x 20 / ((commutation factor x 3) + 20) 

The calculation is also sometimes expressed as: 

Pension x Commutation factor / [1+(0.15 x Commutation factor)] 

Both formula result in the same outcome. In either case the tax-free cash must not exceed 25% of the scheme benefits. 

The residual pension is then calculated as: 

Pension – (max tax-free cash/ commutation factor) 

Where: 

• pension is the member’s pension benefit before commutation; 
• commutation factor is that applicable under the scheme concerned. 
   

• Separate Lump Sum  

Some schemes, particularly older public sector schemes provide an automatic right to tax-free cash in addition to the pension. This is typically at a level of three times the initial annual pension or an accrual of 3/80ths of final salary for each year of service. In this case, taking the tax-free cash entitlement does not reduce the annual pension.

However, these schemes may also allow members the option to increase their tax-free cash entitlement up to the 25% maximum by giving up some of their annual pension.
 

Tax-free cash and AVCs

The maximum tax-free cash that may be taken is calculated at a scheme, rather than arrangement, level. This will allow individuals more flexibility to amalgamate AVCs and other pension benefits within the same scheme to maximise their tax-free cash. It will also allow, for example, the whole of the tax-free cash to be paid from a separate but linked AVC scheme.  

Although the provisions of the simplified regime permit the above it is necessary to check that the rules of the main occupational scheme will allow the tax-free cash to be taken from the associated in house AVC scheme. Where they do it may prove attractive for a scheme member to take their PCLS, as far as possible, from their AVC benefits particularly if the commutation factor under their DB scheme is unattractive.  

Calculating the crystallised value is more complicated for schemes which include both defined benefit and defined contribution elements. The values 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. 
 

Pension Commencement excess lump sum

For both DC and DB schemes, the maximum available tax-free is still limited to the available LSA or LSDBA. Any lump sum in excess of either allowance would be subject to income tax as a pension commencement excess lump sum. 

A pension commencement excess lump sum follows the rules and requirements for a pension commencement lump sum, i.e. a relevant pension needs to commence and up to 25% of that pension can be paid as a lump sum. The difference is that any amount in excess of the available LSA becomes subject to income tax. 
 

Transitional Protections

Where a client has transitional protection, their LSA will be higher than the standard £268,275. 

Type of protection	Lump Sum Allowance
Enhanced or primary protection with no protected tax-free cash	£375,000
Enhanced protection with protected tax-free cash	For each arrangement, the maximum PCLS available on 5 April 2023 based on the protected percentage
Primary protection with protected tax free cash	1.2 x the lump sum rights on the protection certificate
Fixed Protection 2012	£450,000
Fixed Protection 2014	£375,000
Individual Protection 2014	25% of the LTA on the Protection Certificate (£312,250 - £375,000)
Fixed Protection 2016	£312,250
Individual Protection 2016	25% of the LTA on the Protection Certificate (£268,275 - £312,250)

Scheme specific tax-free cash

Individuals who had an entitlement to tax-free cash greater than 25% of the fund on 5 April 2006 retain their rights within the pension scheme. The legislation applies the protection automatically. 

Scheme specific tax-free cash is available where a scheme provides more than 25% tax-free cash. Where applicable, scheme-specific tax-free cash amends the rules for paying a pension commencement lump sum. 

Scheme-specific tax-free cash must be paid from either:

• The scheme that held the rights on 5 April 2006, or, 
• A scheme to which the members rights were transferred as part of a block transfer. 

Additionally, all of the members rights within the scheme must be put into payment at the same time. 

From 6 April 2024 the tax-free rights are calculated using the following formula:

(tax-free cash at 5 April 2006 x 1.2) + 25% of [Current pension value - (value at 5 April 2006 x LSDBA/£1.5m)]

When paying scheme specific tax-free cash, clients are required to have some available LSA, but the tax-free payment is not capped by the LSA but is capped by the LSDBA. If the payment exceeds the LSDBA, the excess is subject to income tax at the client’s marginal rate. 

A client's LSA is not reduced by the amount of the tax-free lump sum paid. Instead, the LSA is reduced by 25% of the total pension value used to pay the scheme-specific tax-free cash. The LSDBA is still reduced by the amount of the tax-free lump sum paid. 

Clients with either enhanced protection or primary protection, with protected tax-free rights in excess of £375,000 are not able to claim scheme specific tax-free cash. Separate rules control the amount of tax free cash available, see our pages on enhanced protection or primary protection for more information. 

If a member’s rights under the scheme after payment of the scheme-specific tax-free lump sum do not exceed £10,000, then instead of paying a relevant pension then the remaining rights may be commuted as a taxable lump sum. 
 

Stand-alone lump sums

Where clients were entitled to access 100% of a pension as a tax-free lump sum on 5 April 2006 this was protected automatically by legislation. The maximum that can now be paid tax-free is capped to the lower of:

• The pension value on 5 April 2023
• The available LSDBA

Any excess above the LSDBA is subject to income tax at the client’s marginal rate. Any fund growth since 5 April 2023 will result in part of the lump sum being subject to income tax. As a result, most stand-alone lump sums will now include an element that is taxable. 

A standalone lump sum is paid instead of a pension commencement lump sum, and without the need for a relevant pension to commence. 

A client's LSA is not reduced by the amount of the tax-free lump sum paid. Instead, the LSA is reduced by 25% of the total pension value used to pay the scheme-specific tax-free cash. The LSDBA is still reduced by the amount of the tax-free lump sum paid.
 

Where tax-free cash can be lower than 25%

There are some circumstances where a member will be entitled to less than 25% tax-free cash.  

• Guaranteed minimum Pension (GMP) 

Plans with GMP may not be able to provide members entitlement to 25% tax-free cash.  

It is not possible to pay any tax-free cash from any rights that must provide GMP. The GMP must be put into payment as an income. Where there are other scheme benefits, then the value of the GMP rights is added to the total rights available to determine the members tax-free cash entitlement, which can be taken from the non GMP rights. 

Where GMP has been bought out for example into a S32 bond, if the fund value is insufficient to provide the GMP rights then this would leave no benefits available to pay any tax-free cash. Or, if the fund is sufficient to cover the GMP, then there may only be a small excess available for a member to take tax-free.
 

• Disqualifying pension credit 

Where an individual receives a pension credit following divorce from crystallised funds, no tax-free cash can be paid from this as the original member will have already received the entitlement.