Tax free cash (2024)

Eligibility to take tax free cash

Tax free cashtypically can only be paid if pension benefits within the scheme are also being brought into payment (or crystallised, as it's known) at the same time. This is why the official term for tax free cash is a pension commencement lump sum (PCLS). The right to tax free cash is lost if an individual chooses not to take tax free cash when they crystallise benefits.

Tax free cash can be paid up to 12 months after the decision to draw tax free cash is made and the pension date has been set, if the scheme allows.

The amount of tax free cash allowed is normally linked to the value of the benefits being crystallised. Therefore it's not usually possible to pay tax free cash without crystallising pension benefits. But there are exceptions to this general rule. These include:

• where tax free cash is paid in isolation under the transitional protection rules for stand-alone lump sums, or
• if the tax free cash is paid after age 75 from 'unused' funds.

Taking benefits after age 75 from 'unused' funds is not classed as a benefit crystallisation event. However, entitlement to a pension still has to occur and the maximum tax free cash is based on the amount of unused funds being designated for pension, either through annuity purchase, income drawdown or scheme pension.

Income doesn't always have to be taken to access tax free cash. Where a contract offers income drawdown, it would be sufficient for the funds to be designated for drawdown and for the individual to choose nil income.

Maximum tax free cash

Generally, up to 25% of the value of benefits crystallised can be paid as tax free cash, as long the amount doesn't exceed 25% of the individual's available lifetime allowance (LTA). For those crystallising benefits in 2023/24 with the full standard LTA available, the maximum tax free cash would normally be £268, 275 (25% of £1,073,100).

However, there are some special circ*mstances where an individual's tax free cash rights can be higher or lower than 25%. These include:

• Where someone has enhanced or primary protection with registered tax free cash
• Where someone has pre A-Day tax free cash greater than 25% which has scheme-specific tax free cash protection
• Serious ill-health lump sums
• Pension credit following divorce where tax free cash has already been taken (a 'disqualifying pension credit')
• Where the fund includes GMP

Also, the scheme's rules might be more restrictive and provide a lower amount of tax free cash. This is unlikely with defined contribution schemes but might happen under defined benefit (DB) schemes - more on these schemes later.

Before age 75 - tax free cash is normally 25% of the value of the fund being crystallised. For example, if a personal pension fund of £100,000 is crystallised, tax free cash of up to £25,000 can normally be provided from this fund.

At or after age 75 - there's no longer a need to take the tax free cash before age 75. However, at age 75, any uncrystallised funds are tested against the LTA, but if no benefits are taken, they’re referred to as ‘unused funds’ from age 75 onwards. When the member eventually decides to take their tax free cash, the amount available will be the lower of:

• 25% of the remaining unused fund coming into payment, or
• 25% of the remaining LTA

When working out the available LTA to provide a lump sum, the amount of LTA used at age 75 by the unused funds is ignored. However, any LTA used up by drawdown funds on their second test at age 75 can restrict the amount of tax free cash available after 75.

If tax free cash is deferred beyond age 75 but the individual dies before it’s taken, the tax free element is lost and any income or lump sums paid would be subject to the beneficiary’s marginal rate of income tax.

Defined benefit (DB) schemes

The general rules on the maximum amount of tax free cash available also applies to DB schemes, although sometime the scheme rules will provide more restricted levels of tax free cash.

Tax free cash from DB schemes is commonly provided by one of two methods:

• Commuting pension for tax free cash - Most private sector DB schemes provide tax free cash by the member giving up part of their pension for cash.

  For example, the scheme rules might stipulate that for every £1 of pension given up the member can take £15 of TFC.

  The precise terms will vary from scheme to scheme and depend on market conditions and the member's age when the tax free cash is paid.

  See Also

  What happens if my pension provider goes bust? | PenfoldPension lump sums5 reasons to pay into a SIPP (Self-Invested Personal Pension)Can I still contribute to a pension after retirement?

• Separate lump sum - Some DB schemes (generally public sector schemes) provide a defined level of tax free cash of, such as 3/80ths of salary for each year of scheme membership. Taking tax free cash in this way would not reduce the member's pension.

  For example, a member retiring with eight years membership on a final salary of £20,000 could receive tax free cash of £6,000 (calculated as 8 x 3/80 x £20,000).

  Some schemes that provide tax free cash as a separate lump sum will also allow some pension to be commuted to provide additional tax free cash to take the overall entitlement up to the 25% maximum.

Commuting pension for cash

The amount oftax free cashavailable using this method is dependent on the tax free cash commutation factor used by the scheme. This will vary from scheme to scheme, but it's typically between £12 to £15 of tax free cash for each £1 of pension given up.

The tax free cash must not exceed 25% of the benefits crystallised. The value given to crystallised benefits within a DB scheme are 20 x pension, plus the face value of cash.

Maximum tax free cash (TFC) can be calculated using the following formula:

• Maximum TFC = (20 x pension before commutation) / (3 + 20/CF)

(where CF is the commutation factor applying to the member under the scheme)

Separate lump sum

Some DB schemes, such as many of the older versions of the public sector schemes, provide a defined retirement pension plus a separate amount of tax free cash. The calculation can vary depending on the scheme but typically benefits are calculated as follows:

• Tax free cash - 3/80ths of salary for each year of scheme membership
• Pension - 1/80th of salary for each year of scheme membership

When these retirement benefits come into payment, a check must be made to ensure that the tax free cash paid isn't more than the maximum allowed (normally 25% of the crystallised value of the total benefits).

Maximum tax free cash can be checked using the following formula:

• Maximum TFC = 25% x [TFC + (20 x actual pension)]

This formula can be simplified to:

• Maximum TFC = 6.666 x actual pension

So long as the defined benefit lump sum is within this limit, it can be paid as tax free cash. If the lump sum exceeds the limit, the excess will be taxed at the member’s marginal tax rate.

Defined benefit and money purchase benefits in same scheme

In some circ*mstances it's possible for a scheme member to have bothdefined benefits and money purchase benefits in the same scheme, for example, where:

• the member has contributed to the money purchase additional voluntary contribution (AVC) section within a DBoccupational pension scheme, or

• the scheme is a hybrid occupati onal pension scheme that provides both defined benefits and money purchase benefits, perhaps for different periods of service or where, for example, a basic defined pension of 1/100th of salary for each year of membership is topped up by a money purchase pot.

Where the scheme member has bothDB and money purchase benefits in the same scheme, the member may be able to choose where the tax free cash is paid from. So if the scheme allows, they could take their tax free cash from the money purchase pot to avoid commuting the pension from the DB arrangement.

The maximum amount of tax free cash that can be paid from these schemes is still limited to 25% of the value of the crystallised benefits. However, calculating the crystallised value is more complicated as it 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.

The following formulae can be used to calculate tax free cash for schemes with mixed benefits:

1. Tax free cash paid from money purchase pot only

   The formula is:

   Maximum TFC = 25% x [MP* + (20 x DB pension)](*MP = the money purchase pension pot)

   See Also

   What happens to my SIPP when I reach age 75?

2. Tax free cash provided by commutation of DB pension only

   The formula is:

   Maximum TFC = [MP + (20 x DB pension before commutation)] / (3 + 20/CF*)

   (*CF = the commutation factor applying to the member under the scheme)

3. Tax free cash from money purchase pot and with top up provided by commutation of DB pension You can use this formula where 100% of money purchase pot is used to provide tax free cash and the remaining balance of 25% is provided by commuting some of the DB pension.

   The formula is:

   Maximum TFC = 20 x [(MP/CF) + (DB pension before commutation)] / (3 + 20/CF)

The tax free cash rules are complicated where there is a mixture of defined benefits and money purchase benefits within the same pension scheme. However using these formulas can make the calculation relatively straightforward.

The following example illustrates how this could work in practice.

Exemptions from the 25% rule

For both defined contribution and defined benefit schemes, the normal tax free cash limit of 25% of the crystallised value benefits within the LTA doesn't always apply, as some individuals may be entitled to either more or less than 25%, for example:

• Enhanced protection with registered tax free cash - Individuals registering for enhanced protection could also protect tax free cash rights if they exceeded £375,000 (25% of the original LTA) at 5 April 2006. This protection was expressed as a percentage of the uncrystallised funds and could be more or less than 25%. This protection will be capped at the tax free cash entitlement on 5 April 2023.

  New contributions can be made after 5 April 2023 without losing this protection, but they will not generate any new tax free cash entitlement.

• Primary protection with registered tax free cash - Individuals with primary protection could protect tax free cash rights if they exceeded £375,000 at 5 April 2006. This could be more or less than 25% of the value of their total uncrystallised benefits.

  The registered tax free cash can be taken from different pension schemes at different times and in different proportions, so long as the total tax free cash taken from all schemes isn't more than the protected amount - there's no link between the crystallised value of the benefits being taken from a scheme and the tax free cash paid from that scheme.

• Enhanced or primary protection – no registered tax free cash - Tax free cash is limited to the lower of 25% of the value of benefits being taken and 25% of (£1.5M less the revalued amount of any previous crystallised benefits).
• Scheme specific tax free cash protection - Before 6 April 2006, occupational pension schemes (including section 32 buyout contracts) could provide more than 25% tax free cash. Under the pre 6 April 2006 rules, tax free cash entitlement was based on the member's salary and service with the employer linked to the scheme.
• Serious ill-health - Where someone's life expectancy is less than 12 months, their entire uncrystallised pension fund can be paid as a lump sum. If paid before age 75, it's tax free as long as it's within the individual's available LTA. After 75, it can only be paid from unused funds and would be subject to income tax at the member's marginal rate..
• Disqualifying pension credit following divorce - No tax free cash can be paid where a pension credit is derived from a pension already in payment (as tax free cash will have already been paid out).
• Guaranteed minimum pension (GMP) - No tax free cash can be paid from GMP. But where other benefits are crystallised at the same type as the GMP, the maximum tax free cash is based on the total crystallised value including the GMP. This can mean that the individual's tax free cash entitlement could be less than 25%.
• Deferred pension benefits within an occupational scheme - Before 6 April 2006, there were circ*mstances where members of occupational pension schemes could draw their tax free cash but defer taking their pension. If they did this after 26 July 2004, no further tax free cash can be paid when they crystallise their pension.

Lifetime allowance

The Spring Budget announced the intention to abolish the LTA from 6 April 2024. For 2023/24, concept of crystallisation events will remain in place, however, there will be no LTA tax charge if benefits over the LTA are crystallised. Existing pension rules which rely on the LTA, including entitlement to tax free cash, will continue to apply.

• 25% of the amount crystallised, or
• 25% of the individual's remaining LTA

If the individual doesn't have any remaining LTA, then there will be no tax free cash.

Where someone is taking their benefits in stages it's important to know how much LTA is used at each crystallisation event and the individual's remaining LTA percentage.

After reaching age 75

At age 75, any uncrystallised funds become referred to as 'unused funds', but they still have to be tested against the LTA. When the member eventually decides to take their tax free cash, the amount available will be the lower of:

• 25% of the remaining unused fund coming into payment, or
• 25% of the remaining LTA

When working out the available LTA to provide a lump sum, the amount of LTA used at age 75 by the unused funds is ignored. The earlier example involving Caitlin demonstrates the calculation.

However, care is needed when deferring taking tax free cash beyond age 75. If other funds were in drawdown before age 75, any growth on those funds is tested against the LTA at age 75 and can use up available LTA. This can have the knock on effect of restricting the amount of tax free cash that can subsequently be taken from the ‘unused funds’.

Of course, the difference in taking tax free cash before or after age 75 will depend on the individual’s particular circ*mstances. Even where there is drawdown fund growth to test at age 75, taking tax free cash before age 75 won’t always give a higher figure – it will depend on:

• the percentage used up by the growth
• the increase (or reduction) in the value of the unused funds by the time the tax free cash is drawn and
• any change in the LTA

Individuals with more than one pension scheme

Normally where someone has more than one pension scheme, each scheme will pay out tax free cash based on the value of benefits crystallised in that scheme. It generally isn't possible to take all tax free cash entitlement from one scheme and pension from the remaining schemes.

The exception to this general rule is where an individual's total tax free cash rights were valued at more than £375,000 at 5 April 2006 and they registered for primary protection. In this situation, the tax free cash can be taken from different pension schemes at different times and in different proportions - provided the total taken from all schemes isn't larger than the protected amount.