Many pension providers offer the opportunity to convert 100% of a “small” pension into a one off cash payment. This is known as trivial commutation and the cash received as a trivial commutation lump sum.
25% of the value of most pension schemes can be converted into tax free cash at the time the pension commences and the same applies to trivial commutation lump sums. So 25% will be free of tax and the remaining 75% will be taxable as normal income in the year in which it is paid.
If a trivial commutation lump sum payment is made in exchange for a pension already in payment, however, then all of that payment will be taxable as normal income in the year in which it is paid.
In all cases, there are rules about how much you can receive as a trivial commutation lump sum, and when you can receive it.
The three rules of trivial commutation
There are three rules that must be taken into account to see if trivial commutation applies:
- the commutation must be made at any time on or after your 60th birthday, but before your 75th birthday;
- the total capital value of the pension that you wish to cash in, plus all of the other pensions to which you are entitled must be within the definition of “trivial”, which is currently not more than £18,000. See below for how this is worked out;
- all trivial commutations that you wish to make must be made within 12 months of the date on which you cash in the first of them. You do not need to cash in all of the pensions you have, but you must cash in the whole of each individual pension.
The £18,000 limit
In order to decide whether you are within the £18,000 limit you must add the value of all your pension entitlements together. How this works will depend on whether you are receiving the pension or not.
For pensions not yet in payment
- If you have a pension from a former employer which is based on your earnings in employment (known as a ‘defined benefit’ pension scheme) they, or the pension scheme administrators, will be able to provide you with a cash value for commuting your pension;
- If you have a personal pension scheme which is based on your own contributions (known as a ‘defined contribution’ pension scheme) you may have a recent statement showing a capital value of your fund which will give you a guide, but it is recommended to get a commutation figure from the pension provider.
For pensions already in payment
- For the purposes of testing against the £18,000 limit, these are valued at 20 times the annual pension income, so a pension of £750 a year, for example, would be given a capital value of £15,000. Any tax-free lump sums that may have been received at the time the pension commenced are added to this capital value (see the example of Mel below).
- It is important to remember that this valuation is for testing against the limit only and the actual amount the scheme will pay out may well be different.
- Different valuation factors apply if you started receiving your pension before 6 April 2006 - in these circumstances you may need to seek specific advice.
If a formal offer of commutation is obtained from a pension provider, you must obtain formal offers of commutation for all of the pensions you wish to commute within 3 months of the date of that first offer and the first of them must actually be cashed in within that 3 month period (see the example of Kim below).
Additional payments allowed within the same tax rules
In addition to the £18,000 limit for trivial commutation lump sum payments, further cash payments in exchange for a pension are allowed. For example:
- up to £2,000 from certain occupational and public service pension schemes, or where payments are made to rectify an error; and
- additional payments of up to £18,000 on the winding up of a pension scheme; or to a beneficiary on death of the person entitled to the pension. These types of payment are not subject to the condition that they must be taken on or after your 60th birthday, but they must still be taken before your 75th.
PAYE on trivial commutation lump sum payments
Tax under PAYE will initially be deducted by the pension payer at the time of making the payment to you. How much tax is taken will depend on your circumstances. There are three typical situations:
- if the trivial commutation lump sum comes from a pension scheme of your former employer, tax will normally be deducted on the basis of the tax code which applied to your earnings immediately before retirement. However this code will be operated on a non-cumulative basis - in other words no account will be taken of any unused tax allowances to which you may be entitled or the cumulative tax you have paid so far in the tax year. This means that only a part of your annual personal allowances and tax rate bands will be applied to the payment, and could result in excessive tax deductions applied to the trivial commutation lump sum;
- if the trivial commutation lump sum comes from a third party provider, for example, an insurance company, and you are able to provide the parts 2 and 3 of the form P45 that you received when you retired from employment to that pension provider, the position will be the same as in 1;
- in all other circumstances, the pension payer is obliged to deduct tax from the trivial commutation lump sum using an emergency code. Once again, this is likely to produce an incorrect tax deduction.
In all cases, the pension payer must provide you with a form P45 (as if you were leaving a job) showing the amount of trivial commutation and the amount of tax deducted. Our experience is that some pension providers are not aware of this obligation under the PAYE rules, so if your pension provider does not, or is unwilling to, provide you with a form P45, refer them this page from the HM Revenue and Customs (HMRC) website, which will help remind them of what they are required to do.
Claiming a refund from HMRC
In many cases you may be having too much tax deducted at the time of receipt of a trivial commutation lump sum payment. Normally, HMRC will check your tax position based upon what they know about you at the end of each tax year and make any repayment due to you then, but you will need to take care and check that any tax calculation and refund you receive from is correct.
If you are certain that you have paid too much tax, you can apply to have a tax refund before the end of the tax year. To do this, you should contact your tax office (the phone number will be on your notice of coding or any other recent correspondence you have had from HMRC) and ask them to send you a form P53 for completion. If you have had no contact with HMRC in the past, you can find telephone numbers on the HMRC website; or you can find them listed under HM Revenue & Customs in the BT ‘phone book, or under Government Offices in Yellow Pages.
The form P53 will ask you to provide details of your income for the whole of the tax year in which you receive the trivial commutation lump sum. This will probably require you to provide estimates of your income for the rest of the year.
You should return the form, together with the parts 2 and 3 of the form P45 given to you when you received the trivial commutation lump sum, to your main PAYE tax office. This may not be the same as the office which relates to your main pension / annuity, but should usually be the same as the office that issues you with the form.
If you do not complete a self-assessment tax return, HMRC may ask you to complete a second form P53 after the end of the tax year to show actual figures and will make any necessary adjustments thereafter.
If you are not resident in the UK for tax purposes (you may well have retired abroad), the above arrangements will not be applicable to you and you should contact HMRC on 0845 070 0040 (or from outside the UK +44 151 210 2222) and ask to be sent a form R43. Alternatively you can download a form R43 from the HMRC website (please note that the form does not load using Chrome but there is no problem with other browsers such as Internet Explorer and Firefox).
Other issues to consider
Trivial commutation is full of rules which can trip you up. Some further issues which you should consider are covered in the next few paragraphs.
Interaction with state benefits
If you are in receipt of a means-tested state benefit (for example, housing benefit or council tax) receipt of a trivial commutation lump sum will increase the level of capital you possess and may have an impact on your ability to continue to claim that benefit.
Similarly, additional capital can reduce or extinguish your entitlement to pension credit. You should consider the position carefully before making the decision to take a trivial commutation payment and may need to take advice.
When to take a trivial commutation payment
It is possible to take a trivial commutation lump sum at any time from age 60, but before you reach age 75. In the tax year in which you have your 65th birthday, and again in the tax year you have your 75th birthday, you may become entitled to increased personal allowances. These increased allowances may absorb much of the tax otherwise payable, particularly if you were a non-taxpayer before you took the lump sum.
Delaying the decision to take a trivial commutation lump sum to a later tax year could produce a saving in taxes. For example, in the tax year in which you retire, you are likely to have higher taxable income and therefore potentially fall into a higher tax band, than you might have in the tax year following retirement.
If you have a number of small pension policies it may be advantageous to cash them in over two tax years, but it is important to remember the 12 month rule.
Payments just outside the trivial commutation lump sum limits
There is no provision that allows for payments outside the cash limits to be made in part tax free and usually your pension provider will not make a payment which takes you over the limit. So be very careful because if, as a result of receiving several trivial commutation payments which together take you over the £18,000 limit (and assuming none are additional ‘allowed’ payments of the type mentioned above), then all of the trivial commutation lump sum payments you have received may become subject to a penalty rate of taxation of 40%. This is particularly important to be aware of when commuting several pensions on separate occasions within the 12 month commutation period.
| Examples Two examples may help to illustrate the principles: Kim, age 62, has pensions not yet in payment under three registered pension schemes A, B and C where the policies are worth £3,000, £2,500 and £4,000 respectively. Kim is not in receipt of any pension in payment. The rules of all three of her pension schemes allow the commutation of trivial pensions. Kim wants to commute her benefits as soon as possible in the 2013 calendar year and in order to do this her pension benefits must be valued within a 3 month period ending on the date the first trivial commutation lump sum is paid. Kim’s pension rights are valued on 5 January 2013 at £9,500. To be a valid valuation, the first trivial commutation lump sum payment must be paid before 5 April 2013 (within 3 months of the valuation). Kim does not have to take her benefits as a trivial commutation lump sum from each scheme. She may choose to take her benefits under one or two of the schemes and not the other(s). But it must be an all-or-nothing decision in relation to each scheme i.e. all the arrangements within an individual scheme (A, B or C) must be paid as a trivial commutation lump sum, or none of them. Kim decides to draw all her benefits under scheme A (£3,000) and B (£2,500) as a trivial commutation lump sum and the benefits under scheme A are paid out as a trivial commutation lump sum on 2 February 2013. The date this first payment is made will be the first day of the 12-month commutation period. Kim must draw any further trivial commutation lump from her remaining registered pension schemes before this period ends on 1 February 2013. Any payment from scheme B must therefore be paid by that date and represent all her rights deriving from any number of policies under that scheme. The benefits under scheme B are actually paid on 5 March 2013 (within the commutation period) and Kim decides to leave the benefits held under scheme C. She can change her mind and decide to fully commute these benefits up until 1 February 2014, but after this date the chance to commute those benefits is lost. Mel, who is 64 in the tax year 2012/13, has pensions not yet in payment from scheme X, Y and Z with capital values of £1,000, £2,100 and £3,000 respectively (£6,100 in total) on 5 January 2012. She also receives a pension of £1,000 from scheme W which started in the 2011/12 tax year. At the same time the scheme pension started Mel was also paid a tax-free lump sum of £2,200. Her pension rights from scheme W are valued at £22,200 (20 times £1,000 plus £2,200). This means Mel’s total pension rights are worth £28,300 (£6,100 and £22,200) on 5 January 2013 and this is more than the commutation limit of £18,000. So none of Mel’s benefits under scheme Y or Z may be commuted and paid as a trivial commutation lump sum, nor can her pension in payment from Scheme W be commuted. Mel might, however, be able to commute her pension under scheme X if it comes from a qualifying occupational or public sector pension scheme under the additional £2,000 limit mentioned above.
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Need more help?
This can be a complex area of tax law and practice. For help on the tax aspects of trivial commutation (including filling in forms), if you are aged 60 or over and cannot afford to pay for tax advice, you can call TaxHelp for Older People (TOP) on 0845 601 3321 for assistance. Information on TOP can also be found on their website.
For benefits issues, you might be able to get help from an advice agency such as your local Citizens Advice Bureau, but for queries as to the technical issues surrounding trivial commutation (for example, valuations), your first contact should be with your pension provider(s).
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