Tax-Free Cash Planning with Scheme Specific Tax

Prior to 6 April 2006, an individual’s tax-free cash rights from money purchase (defined contribution) occupational pension schemes (OPS) were typically calculated based on the length of service with the employer and the employee’s pensionable earnings. Consequently, for these schemes, the tax-free cash rights available as of 5 April 2006 (A-Day) could have exceeded 25% of the fund value. As part of the A-Day pensions “simplification” changes tax free cash rights were generally capped at 25% of the pension fund value (subject to the individual having sufficient Lifetime Allowance). In circumstances where the tax-free cash rights in an OPS at A-Day exceeded 25% of the A-Day fund value, these tax-free cash rights usually qualified for a form of protection commonly known as “scheme-specific tax-free cash protection” (SSTFC). Despite numerous changes to pension regulations since A-Day, this form of tax-free cash protection persists and continues to provide valuable rights to clients.

Under certain conditions, pension rights with SSTFC can transfer without losing the protection. Broadly speaking, the protection continues if the transfer is:

• Part of a block transfer (two or more members transferring from the same scheme, at the same time, to the same receiving scheme), or
• As a result of a scheme wind-up, in which case the benefits must be transferred to a deferred annuity contract.

The calculation of the tax-free cash when SSTFC applies is not based on the percentage of tax-free cash rights at A-Day, although the fund value and tax-free cash rights at this date do form part of the calculation. The calculation consists of two parts which, for money purchase schemes, can usually be set out as follows:

• A-Day tax-free cash amount x 1.2

Plus

• 25% x (fund value at retirement – (fund value at A-Day x 0.7154))

So, for a client who is crystallising benefits with SSTFC with a current fund value of £650,000, and A-Day tax-free cash of £75,000 and A-Day fund value of £200,000, the SSTFC amount can be calculated as:

• £75,000 x 1.2 = £90,000

Plus

• 25% x (£650,000 – (£200,000 x 0.7154)) = £126,730

= £90,000 + £126,730 = £216,730

The figure of £216,730 compares very favourably with the standard amount based on 25% of the fund value, £162,500.

For clients with individual or fixed protection, the second part of the calculation changes. In particular, the factor of 0.7154 that is applied to the A-Day fund value is adjusted to take account of the lifetime allowance protected value. The 0.7154 is calculated based on £1,073,100 / £1,500,000. For clients with fixed or individual protection, the value of £1,073,100 is replaced by their lifetime allowance protected value. For example, a client with fixed protection (2014) will have a lifetime allowance protected amount of £1,500,000, therefore the factor to use in the calculation is £1,500,000 / £1,500,000 = 1. The revised calculation then becomes:

• £75,000 x 1.2 = £90,000
  • Plus
• 25% x (£650,000 – (£200,000 x 1)) = £112,500
  = £90,000 + £102,500 = £202,500

So, whilst the calculation is not as generous for a client with fixed or individual protection it still offers a significant improvement over the standard calculation.

It should also be noted that the protected lump sum amounts can only be paid if all the scheme benefits are crystallised simultaneously. Partial crystallisation will result in the calculation of tax-free lump sums based on the standard basis of 25% of the amount crystallised.

Impact of the Lump Sum Allowance and Lump Sum Death Benefit Allowance

Tax-free lump sums with SSTFC can only be paid if the client has not used all of their Lump Sum Allowance. However, unlike a normal tax-free lump sum, they are not restricted to the available Lump Sum Allowance and will remain tax-free provided they do not exceed the available Lump Sum and Death Benefit Allowance. For clients with tax-free cash rights in more than one scheme, if one of the schemes has SSTFC protection, it may be beneficial to crystallise these benefits only after tax-free cash has been taken from other schemes.

Example

Suppose we have a client with a Lump Sum Allowance of £268,275 and a Lump Sum Death Benefit Allowance of £1,073,100. They have a personal pension plan worth £1 million that does not have SSTFC and available tax-free lump sum is 25% of the fund value, £250,000. They also have a Section 32 policy with SSTFC, where the tax-free lump sum rights are £200,000.

If the benefits from the Section 32 policy are crystallised first, the remaining Lump Sum Allowance after crystallisation will be calculated as £268,275 – £200,000 = £68,275. When the client subsequently crystallises benefits in the personal pension plan, the tax-free lump sum will be restricted to the remaining Lump Sum Allowance of £68,275.

However, if the client crystallises the personal pension plan first and takes their tax-free lump sum of £250,000, their remaining Lump Sum Allowance will be reduced to £268,275 – £250,000 = £18,275. As the lump sum from the Section 32 policy is not restricted by the available Lump Sum Allowance and does not exceed the available Lump Sum and Death Benefit Allowance, they can still receive the full amount of £200,000. This results in total tax-free lump sums for the client amounting to £450,000, instead of £268,275.

If you would like more information, please feel free to contact the Technical Services Department.

All information is based on our understanding and interpretation of applicable law and regulation.

 

 

 

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