A simple guide to understanding pension commencement lump sums

This month, Bluesky’s very own Rob Starling breaks down some of the key details of the pension commencement lump sum (PCLS), formerly known as the “tax-free lump sum.” From its maximum value to the eligibility criteria, discover everything your clients need to know to make the most of this important benefit.

Over to you, Rob.

Rob’s guide

For most of the 25 years or so that I have worked in financial services, someone somewhere has started the “rumour mill” in the buildup to the Budget that the rules covering the PCLS are set to change.

Well, another Budget has gone by, and once again, the PCLS – often known as the “tax-free lump sum” – has been left alone.

Pity the individuals who panicked and withdrew funds from their pensions on the back of certain media outlets stirring up a storm. I wonder if a class action against unregulated advice peddled by such outlets might ever occur?

So, what exactly is the PCLS and what should you know about it?

Read on as I break down the basics and key technical details.

The basics

  • While most people likely still refer to a tax-free lump sum, the PCLS is technically the correct title.
  • For defined contribution (DC) pensions, in most instances, the PCLS will be 25% of the fund value.
  • As the old name suggests, the PCLS is tax-free when extracted from the pension and doesn’t need to be declared on a tax return.
  • It is not necessary to take the PCLS in one go – you could take regular or ad hoc PCLS payments until the allowance has been fully used.

A bit more technical

  • You can currently access the PCLS from age 55. This is known as the “normal minimum pension age” (NMPA). However, the NMPA is set to align with the State Pension Age minus 10 years. This means that the minimum age of access will increase to 58 from 6 April 2028 when the State Pension Age rises to 68.
  • Defined benefit (DB) PCLS entitlements are less straightforward to work out, not least because taking the PCLS can sometimes result in the reduction of the expected income.
  • Some older DC schemes can have an entitlement to a PCLS greater than 25%.
  • DC pensions usually won’t have access to a lump sum if someone has taken it already. This can happen if you share a pension that has already had the PCLS extracted, perhaps by a spouse using a pension credit. This is referred to as a “disqualifying credit”.

A lot more technical

  • Although the previous government removed the Lifetime Allowance (LTA), its legacy still has an impact.
  • In place of the LTA, new pension allowances have arrived – the Lump Sum and Death Benefit Allowance (LSDBA) and the Lump Sum Allowance (LSA).
  • The LSA stipulates that the maximum PCLS someone can take is capped at 25% of £1,073,100, which is £268,275. The £1,073,100 may look familiar as it is the final resting point of the old LTA. Having a pension fund above £1,073,100 is not the norm, but a large number of people will still be impacted by this cap.
  • Individuals, who under the LTA regime, applied for one of the many protections offered throughout its existence, are likely to still benefit from having the protection in place. So, for example, someone who had obtained Fixed Protection 2016, would see their LSA set at £312,500.
  • For a younger person who has yet to take any of their pension benefits, the LSA calculation is relatively straightforward. However, things can quickly become more complex when dealing with an individual who has already taken some pension benefits, particularly if the pension income originated from a DB scheme. In such cases, a more detailed calculation may need to occur and an application for a “transitional tax-free amount certificate” may need to be obtained from the administrators of the scheme (who must comply within 3 months).

Pulling it all together

Typically, the reason for discussing pensions in the context of divorce is either for the couple to share them equitably or to make an allowance for them to offset other marital capital in some way.

The ability to release capital (in the form of the PCLS) can, in certain circumstances, help to balance up a settlement elsewhere.

It may be an obvious point, but you should be mindful of not straying into the provision of regulated financial advice.

As I wrote that sentence, I was reminded of a case where a solicitor suggested a pension was fully encashed to release short-term capital during a divorce. While 25% of the fund was tax-free, 75% was subject to Income Tax (not foreseen).

Worse still, the ability of the member to rebuild their pension assets post-divorce was severely inhibited by triggering the Money Purchase Annual Allowance (MPAA), which drops the Annual Allowance an individual can contribute tax-efficiently from £60,000 to £10,000. The MPAA comes into effect when an individual has drawn taxable income beyond simply taking the PCLS.

The PCLS remains a cornerstone of UK retirement planning. There are times when it might present a useful tool for the practitioner in reaching a settlement. So, having an understanding of the “high-level” rules is important. But equally, remember that help is at hand if extra reassurance is required.

We are always happy to help.

Get in touch

To find out more about how we can help you and your clients navigate the financial complexities of their pension, get in touch.

Email info@blueskyifas.co.uk or call us on 0118 987 6655.

Please note

This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits.

This article is for information only. Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.