For those with small pension funds, where it might be impractical or impossible to purchase an annuity, an alternative could be to commute the whole fund(s) for cash.
The legislation provides for trivial benefits to be commuted and paid as a one-off lump sum payment once the member has reached the age of 60 but has not reached age 75. This can be done only if the value of the member’s benefit entitlement under all registered pension schemes, along with all rights that have previously crystallised (ie become payable) for lifetime allowance purposes (including any pensions in payment on 5 April 2006), do not exceed a maximum value (the commutation limit) as valued on a specific date (the nominated date).
The combined value of those rights is referred to as the member’s pension rights. A member does not have to retire to apply for a trivial commutation lump sum.
The commutation limit, referred to above, is currently £18,000.
Where crystallised rights are paid as a trivial commutation lump sum the whole payment will be taxed as pension income. Where uncrystallised rights are paid as a trivial commutation lump sum, only part of the payment will be taxed as pension income. This is because normally, one quarter (25%) of the uncrystallised rights can be paid in cash, tax free. Pension income is taxable under the PAYE system.
A pension scheme member aged 61 has a total fund of £12,000.
The member applies for a trivial commutation lump sum, and is paid the following: -
£12,000 x 25% = £3,000 tax free
£12,000 x 75% = £9,000 which is added to taxable income in the year of receipt*
* Income tax will be deducted at source at the rate of 20%, under the PAYE system. Any income tax that has been ‘overpaid’ can be reclaimed from HMRC.