Pension commencement lump sum (PCLS)

What is PCLS?

The pension commencement lump sum (PCLS or commonly known as tax-free cash) is the amount of money available ‘tax free’ to the member as a lump sum when they take benefits.

The rules on the maximum tax free amount vary depending on individual circumstances, in particular whether they had any Lifetime Allowance (LTA) protection or had lump sum rights in excess of 25% on 5th April 2006. 

Technically, a Standalone Lump Sum is not a PCLS.

What is the permitted maximum?

There’s an upper limit on the amount of pension commencement lump sum (PCLS or more commonly known as tax-free cash/ TFC) available to a member when they take benefits.

In broad terms, it’s usually limited to the lower of:

• 25% of the value of the member’s uncrystallised pension rights being put into payment,
• the individual's available Lump Sum Allowance (LSA), and
• the individual's Lump Sum and Death Benefit Allowance (LSDBA).

The monetary amount of each PCLS payment is deducted from the individual's LSA and LSDBA. 

What conditions must be met to pay a PCLS?

The six conditions a member must meet to receive a PCLS are:

• entitlement to PCLS is connected to an entitlement to a relevant pension
• the member has some LSA or LSDBA available at the time of payment
• the lump sum must be paid in the period 6 months before and 12 months after the member becoming entitled to the relevant pension
• the lump sum is not paid before the member has reached the normal minimum pension age (or meets the ill health condition)
• the lump sum is not an excluded lump sum
• the amount which can be treated as a PCLS is an amount that does not exceed the permitted maximum.

If any of these conditions are not met, the lump sum is classed as an unauthorised payment, not a PCLS. Additionally, it’s important to note that the tax-free element paid within an uncrystallised funds pension lump sum (UFPLS) is not a PCLS –see our Uncrystallised Funds Pension Lump Sum article

You can find further details from the HMRC Pension Tax Manual.

Here’s a little more detail about these conditions:

Entitlement

For a PCLS to be payable, the member must become entitled to either flexi-access drawdown, a lifetime annuity or a scheme pension (further designation to a capped drawdown plan established before 6 April 2015 will also generate a further PCLS in respect of the newly crystallised funds). Entitlement arises when the member has an 'actual right' to receive a pension (although they don’t necessarily need to actually draw that income).

Lump sum allowances

In order to receive a pension commencement lump sum, the member must have sufficient Lump Sum Allowance and Lump Sum and Death Benefit Allowance available. 

What happens when allowances are insufficient?

Where the member doesn’t have sufficient allowances to pay the tax free lump sum will depend on scheme rules.

The lump sum could be capped at the tax free amount. Alternatively the amount in excess of the permitted maximum might be paid as a Pension Commencement Excess Lump Sum or some other type of allowable payment.

Any tax free amount paid in excess of the permitted maximum will be an unauthorised payment unless it meets an authorised pension payment rule. 

Timing of lump sum payments

The lump sum must be paid in the time between 6 months before and 12 months after the member becomes entitled to the relevant pension. In practice, the lump sum is normally paid once the scheme administrator has received the member's signed acceptance forms and at the same time as the pension is set up. 

SI 2006/135 The Registered Pension Schemes (Meaning of Pension Commencement Lump Sum) Regulations 2006 as amended by SI 2007/3533

PCLS can’t be paid unless the member has reached the normal minimum pension age, satisfies the ill-health criteria, or they have a protected early retirement age.

There are two main types of excluded lump sum:

• one that is based on an overinflated bridging pension. As the amount of PCLS payable is based on the amount of pension payable, HMRC recognise that a scheme may provide the member with a pension for a limited period (bridging pension), artificially increasing the amount payable in order to increase the amount of PCLS payable. Any lump sum paid in these circumstances does not qualify as a PCLS payment.
  
  
• it is not possible to pay a lump sum from a disqualifying pension credit (pension sharing transfer on divorce) that originated from crystallised rights.

Paragraph 1(1)(f) and (4) Schedule 29 Finance Act 2004

How to calculate the amount of tax-free cash

This is slightly different for different types of pension and is known as the applicable amount.

The applicable amount post the abolition of the LTA is the same as it was prior to abolition. 

Defined contribution schemes

It's one third of the annuity purchase price or amount designated to drawdown (excluding any amounts derived form crystallised rights or a disqualifying pension credit)

Defined benefit schemes

The calculation is 25% x (tax-free cash + residual value), but a commutation factor is needed.

Max cash = (20 x commutation factor x yearly scheme pension before commutation)
                                                      20 + (3 x commutation factor)

You may recognise the formula above expressed as

Max cash = Pre-commutation pension x Commutation factor
                                                      [1+(0.15 x Commutation factor)]

The second formula is used within many exam study texts. It’s important to note this formula gives exactly the same answer as the previous (HMRC preferred) method.

Paragraph 1 to 3 Schedule 29 Finance Act 2004