Small lump sums

These FAQs are for financial advisers only. They mustn’t be distributed to, or relied on by, customers. They are based on our understanding of legislation at the date of publication.

There are a number of situations described in HM Revenue & Custom’s (HMRC) Pensions Tax Manual where it’s possible for funds held in a pension arrangement to be commuted for a small lump sum. These FAQs cover each of these scenarios and the conditions to be met for a small lump sum payment to be made in each case.

Note that legislation does not require registered pension schemes to offer the payment of small lump sums. The rules of each scheme will cover whether or not small lump sums can be paid.  

Scheme administrators may sometimes find themselves holding small amounts of money for members who have either taken their benefits or transferred their funds to another scheme. Typically this could arise because after benefits have been taken or a transfer has been made:

  • a payment is made to the scheme which is not a contribution (note that contracted-out contributions are not treated as contributions for this purpose).
  • further funds have been sent to the scheme, or
  • it is discovered there is an increase in the value of the member’s arrangement above which the scheme administrator expected, or
  • the scheme administrator becomes aware that the member is entitled to a further benefit that it was not previously aware of. 

Practical situations where one of the above scenarios could happen include:

  • where there is an unexpected investment return, for example, where a dividend payment is received after the member has taken benefits or transferred funds.
  • where there has been a unit pricing issue or valuation error causing an undervaluation of a fund or transfer value.
  • where a redress payment is proposed to be made into a pension arrangement. 

Both of these could result in additional funds being held for an individual in a scheme where they had previously taken benefits or arranged a transfer from. These additional amounts are referred to in HMRC guidance as ‘relevant accretions’ and can be paid as a small lump sum if the following conditions apply and scheme rules allow:

  • a transfer has been made from a registered pension scheme to another registered pension scheme or to a qualifying recognised overseas pension scheme, or
  • a scheme has purchased a scheme pension or lifetime annuity from an insurance company. Where the purchase was made on or after 6 April 2006, the member must have had some or all of their lifetime allowance remaining at that time.
  • the payment of the small lump sum extinguishes the member’s entitlement to benefits under the pension scheme (but where a scheme pension or lifetime annuity was purchased, the scheme pension or annuity is ignored when determining whether the member’s entitlement to benefits under the scheme have been extinguished).
  • the small lump sum does not exceed either £10,000 or the value of the relevant accretion and is paid within six months of the accretion payment being received or identified.  

Such a payment can be made to the member or in respect of the member, if the member has died.

The Financial Services Compensation Scheme (FSCS) is a statutory fund that aims to compensate policyholders if a financial services firm becomes unable or unlikely to be able to pay claims against it. Generally, this would be where a firm has ceased trading and has insufficient assets to meet claims, or goes into liquidation.

A compensation payment made under the FSCS can be paid as an authorised lump sum if: 

  • the payment does not exceed £10,000.
  • it extinguishes the member’s entitlement to benefits under the registered pension scheme. 

The payment doesn’t actually have to be made by the pension scheme itself. That is, it can be made directly by the FSCS and can be made either to the member or in respect of the member if the member has died.

A small lump sum can be paid to allow an individual to take a small fund held in a pension arrangement as a lump sum as an alternative to setting up an annuity for a modest amount. In effect, the fund that would normally be set aside to provide an annuity can be commuted for a one-off taxable lump sum. According to HMRC guidance, a small lump sum can be made from uncrystallised or crystallised funds and can be made: 

  • providing the conditions for paying the small lump sum are met, and
  • irrespective of the possible size of pension funds that an individual may hold elsewhere. For example, an individual could commute a fund held in a personal pension for a small lump sum even if they hold larger funds in other pension arrangements. 

There are different conditions to be met depending on the type of pension arrangement that the small lump sum is being paid from. HMRC guidance lists the following three categories: 

  • payments from occupational or public service pension schemes.
  • payments from larger occupational or public service pension schemes.
  • payments from non-occupational or non-public service pension schemes.  

It will sometimes be the case that a member’s fund will only buy a very small pension but the conditions that would allow the fund to be paid as a trivial commutation lump sum are not met. As an alternative, it may be possible to pay a small lump sum subject to the following being met: 

  • the individual is at least age 55 or is taking benefits at an earlier age through ill-health or because they have a protected pension age.
  • the member is neither a controlling director of a sponsoring employer of this or of any related scheme nor connected to such a controlling director.
  • the ‘commutation value’ of the benefits to which the member is entitled under this and any related scheme is not more than £10,000 (this means that if someone is a member of two or more occupational or public service schemes which are registered pension schemes and relate to the same employment, their total benefit value across all such schemes must be no more than £10,000).
  • the payment extinguishes the member’s entitlement to benefits under the paying scheme.
  • no recognised transfer has been made out of this or any related scheme in respect of the member during the three years preceding the date of the payment. 

The commutation value is equal to the amount of the lump sum paid - this is the actual value paid out as opposed to the 20:1 valuation factor used for final salary benefits being tested against the lifetime allowance.

There is no limit on the number of small lump sum payments that can be made and the payment can be made either to the member or in respect of the member, if the member has died. 

A larger occupational or public service pension scheme is essentially one which has at least 50 members in the scheme. To allow a small lump sum payment to be paid from a larger occupational or public service pension scheme, the same conditions apply as listed in the section above for an occupational or public service pension scheme, except that a small lump sum can be paid from a ‘larger’ scheme even if the member has benefits in another scheme for the same employment. The following conditions therefore apply for making a small lump sum payment from a larger occupational or public service pension scheme: 

  • there are at least 50 members in the scheme.
  • the member has reached the age of 55 or is taking benefits at an earlier age through ill-health or because they have a protected pension age.  
  • the member is neither a controlling director of a sponsoring employer of this or of any related scheme nor connected to such a controlling director.
  • the payment does not exceed £10,000.
  • the payment extinguishes the member’s entitlement to benefits under the paying scheme. If benefits are held in another scheme for the same employment, then those benefits don’t have to be paid as a small lump sum as well.
  • no transfer in from any other pension scheme (whether a registered pension scheme or not) was made into the scheme in relation to the member during the five years preceding the date of the payment, except where the transfer was an ‘acceptable transfer’ (as described below).
  • no recognised transfer to a registered pension scheme or qualifying recognised overseas pension scheme was made out of this scheme in respect of the member during the three years preceding the date of the payment.
  • the scheme is able to satisfy at least one of the following conditions:  
  • the scheme was in existence on 1 July 2008, or
  • the payment is in respect of a defined benefits arrangement and the value of the defined benefits is more than half of the value of the total benefits under the scheme (that is, the scheme is mostly funded as a defined benefit scheme).
  • there are at least 20 members whose benefit value is more than £10,000. 

An acceptable transfer is a full or partial transfer from a defined benefit or cash balance arrangement to a defined benefit or cash balance arrangement under the scheme making the small lump sum payment, provided that: 

  • where the transfer is being made in connection with the winding up of the original pension scheme containing the defined benefit or cash balance arrangement, the receiving defined benefit  or cash balance arrangement relates to the same employment, or
  • the transfer is being made in connection with a ‘relevant business transfer’, or
  • the transfer is being made as part of a ‘retirement-benefits activities compliance exercise’. 

Each of these three points are covered in the HMRC Pensions Tax Manual at:

https://www.gov.uk/hmrc-internal-manuals/pensions-tax-manual/ptm092420

There is no limit on the number of small lump sum payments that can be made and the payment can be made either to the member or in respect of the member, if the member has died. 

This category is relevant for funds held in a personal pension, retirement annuity, section 32 buyout and trustee proposed buyout. Funds held in a these types of pension arrangement can be commuted for a small lump sum if:

  • the individual is at least age 55 or is taking benefits at an earlier age through ill-health or because they have a protected pension age.
  • the small lump sum payment does not exceed £10,000.
  • the payment represents the full value of the member’s benefits held under the pension arrangement being commuted.
  • the member has not previously received more than two small lump sum payments from other pension arrangements. 

In effect, an individual can commute a maximum of £30,000 through taking a total of three small lump sum payments from three different pension arrangements under this option. These arrangements could be held with different providers or with the same provider. Where they are paid by the same provider, then the small lump sum payments can be paid from arrangements held in different registered pension schemes or from ones held in the same registered pension scheme.

It is possible for a small lump sum payment to be paid from an arrangement held in a registered pension scheme where an individual holds other arrangement(s) in the same scheme that are not being commuted.

Care needs to be taken when commuting a pension arrangement that is very close to the £10,000 limit as it is the value at the claim date that is relevant. For example, a quote may be issued by a provider for a small lump sum of £9,900 but the value of the pension arrangement could have increased to more than £10,000 through fund growth, additional contributions or benefit accrual by the time the claim paperwork is returned.

There is scope to allow arrangements to be merged or for funds to be transferred between arrangements in order to allow a small lump sum to be paid. Whilst HMRC guidance confirms this can be done, it will depend on a provider’s scheme rules, systems and processes what is actually possible in practice.

Where someone has enhanced or fixed protection (2012, 2014 or 2016), and new arrangements are created in a scheme to allow funds to be paid as a small lump sum (for example, where funds above the small lump sum limit are held in one arrangement), then this could result in the fund protection being lost. 

If a small lump sum payment is paid from uncrystallised funds, then 25% of the fund can be paid tax-free with the balance subject to income tax as pension income in the tax year the payment is made.

When a small lump sum is paid to someone who is not the member (that is, where the member has died, the lump sum will be taxed on the recipient as income in the tax year in which the payment is made.

A provider will use the basic rate tax code (BR) for the payment, which may mean that an individual ends up paying too much or too little tax. The amount of tax the member (or the recipient, where the member has died) pays in a tax year will depend on their total taxable income for the tax year. In practice, this means a basic rate taxpayer or non-taxpayer could pay too much tax and a higher or additional rate taxpayer may need to pay more tax through self-assessment, as the tax on the lump sum will only have been deducted at the basic rate of 20%.

If too much tax is paid, the recipient can claim it back and there is guidance on how to do this here.

Where a small lump sum is paid from crystallised funds, then all of the payment is subject to income tax as pension income in the tax year the payment is made. Typically, a provider will use the PAYE code already in operation.

A small lump sum payment is not classed as someone flexibly accessing their benefits so won’t trigger the money purchase annual allowance (MPAA) rules. 

The payment of a small lump sum is not classed as a benefit crystallisation event. As a result, there is no test against the lifetime allowance and an individual does not have to declare that they have enough lifetime allowance remaining to allow a small lump sum payment to be made.

Pensions Technical Services