Where small pots exist, taking small pot lump sum payments can be useful in financial planning, not least as they do not trigger the money purchase annual allowance, nor do they use or require the individual to have any available lifetime allowance. Joshua Croft, technical consultant at AJ Bell, explains.
There are many reasons why someone might end up with several small pensions; for example, from short periods of employment particularly since the introduction of auto-enrolment, as workers change employers. The smaller pension pots are unlikely to provide any meaningful retirement income through drawdown or annuity purchase.
However, changes made with pension freedoms introduced from 6 April 2015, now mean that anyone with a defined contribution pension can withdraw their whole pension fund from the normal minimum retirement age as an uncrystallised funds pension lump sum (UFPLS).
There is also a set of provisions, known as the ‘small pot rules’, which allow individuals to take smaller pensions as a one-off lump sum without going through more traditional methods.
There are several types of small pot lump sum payments available. However, for members of defined contribution schemes the main set of rules is referred to as “Payments under a scheme that is not an occupational or public service pension scheme”.
What are they
An individual’s personal pension arrangement can be fully commuted under the small pots rule where it complies with the following requirements:
– They have reached the normal minimum retirement age (currently 55) except in cases of ill health or if the individual has a protected pension age.
– The payment does not exceed £10,000.
– The payment extinguishes the member’s entitlement to benefits under the arrangement.
– A member can take a maximum of three small pots payments from non-occupational schemes, though there is no limit on the number of small pots payments from unconnected occupational pension schemes.
Unlike the old trivial commutation lump sums that these payments essentially replaced, these payments can be made regardless of the value of the individual’s total pension savings.
If the small pot lump sum is being paid from uncrystallised funds, then 25% of the lump sum will be tax free, and 75% is taxed as income at the individual’s marginal rate of income tax in a similar way UFPLSs are taxed.
Small pot vs UFPLS
Small pots may seem very similar to UFPLS but there are a few key differences that could be beneficial. Small pots do not trigger the money purchase annual allowance (MPAA) where as an UFPLS payment of any amount does, reducing the level of future potential contributions.
Small pots can technically be paid from crystallised pension funds, UFPLS can only ever be paid from uncrystallised funds.
And notably small pots are not a benefit crystallisation event, therefore do not use or require the individual to have any available lifetime allowance (LTA). So, an LTA excess charge can be avoided where someone with no remaining LTA has a pension arrangement worth up to £10,000.
This could potentially create planning opportunities, and a single pension over £10,000 could be split up in to three separate arrangements. This could effectively give someone an extra £30,000 of lifetime allowance. It would rely on the provider being able and willing to separate a single pension into the multiple arrangements.
This creation of artificial small pots doesn’t seem to be prevented by the legislation, but you could argue it’s not within the spirit of the rules.
There is a risk that HMRC could see this process as an avoidance exercise. In their own definition of tax avoidance they say ‘It often involves contrived, artificial transactions that serve little or no purpose other than to produce this advantage. It involves operating within the letter, but not the spirit, of the law.” Artificially creating three pension arrangements, to then make withdrawals under rules intended to assist those with smaller stranded pots purely to avoid or reduced a LTA excess charge – would seem to fit this description.
