(Article updated 6th December 2011)
Under current UK pensions legislation your pension fund ultimately has to provide you with a retirement income. Alternatively, it is possible to take a small slice of your fund as a tax-free lump sum (usually 25%) while the balance is used to purchase an income. But, if the value of your pension rights is below £18,000, it is possible to give up your rights entirely in exchange for a much larger one-off cash lump sum.
From 6 April 2006, this option, called trivial commutation, is available to those where the total value of all their pension rights does not exceed 1% of the Lifetime Allowance. So for the 2011/12 tax year this equates to £18,000. However, from April 2012 the link to the lifetime allowance will be removed and the threshold will continue to be £18,000.
Wow! Hold on, will the whole lump sum be tax-free?
Not quite, if you do cash-in a pension under triviality rules, a quarter of the cash paid is tax-free with the remainder treated as taxable income in the year it is received. So if you happen to be a non-income tax payer at the point of cash-in then the majority of the lump sum will end being tax-free.
Blimey! So how do I value my existing pension rights to see if I qualify?
The Pensions Advisory Service website provides full details, so follow this link. The key thing to remember is that the calculation takes into account all pension benefits, be it personal pensions, money purchase schemes or final salary – whether they are already in payment or not.
Right, I’m under the limit! Are there any other restrictions?
Yes. The pension in question must be cashed in by anyone over the age of 60. In addition, if you wish to cash-in more than one pension you must do so within 12-months of cashing-in the first one. You will not be able to cash-in any pensions after that 12-month period has expired.
(update 6th December 2011: HMRC has announced changes to pension legalisation which will allow individuals to access those savings held in small personal pension schemes i.e. £2,000 or less, by way of lump sum payment. The changes will be effective from 6th April 2012).
There are one or two other restrictions relating to occupational schemes, but once again, full details can be found by following the above link.
Are there any drawbacks from pursuing this course of action?
Yes. By commuting your pension fund you are giving up your right to any future pension benefits. Similarly, you and your family will lose any entitlement to death benefits under the scheme. So make sure your financial adviser explains this to you.
So to sum up, if you have small pension pot which will provide you with next to no income, via an annuity or an unsecured pension, you may instead, with a bit of careful planning, be able to release the cash from your pension as one lump sum.
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