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What is the Pension Commencement Lump Sum?
Your Pension Commencement Lump Sum (PCLS), which is often known as the ‘tax-free lump sum’, is a tax-free cash amount which most people are eligible to receive when they start accessing their pension benefits. The figure normally equates to 25% of the value of the pension benefits being accessed. Whilst this amount is free of tax in the UK, it could be taxable in your country of residence.
The tax-free amount can be an amount as high as £263,750 – this figure is 25% of the Lifetime Allowance (LTA) of £1,055,000. The LTA increases each year in line with the Consumer Prices Index (CPI).
What are uncrystallised and crystallised funds?
Pension funds which have not been accessed are known as being uncrystallised. Meaning these funds have not been tested against your Lifetime Allowance amount. As such, your PCLS can only be taken from your uncrystallised funds, at the point you opt to crystallise them.
Crystallised funds, therefore, are funds which have been tested against the Lifetime Allowance and designated to provide pension benefits.
Do I have to take all my PCLS in one go?
Normally, no. In most cases, you will not need to take your whole PCLS in one go, in the same way that you are not normally expected to access all your pension benefits at once, unless you have a defined benefit scheme.
If your pension is worth £800,000 you can take up to £200,000 as PCLS. You may not wish to take your entire PCLS in one go and only wish to receive £20,000 (10%) of your PCLS initially. To do this you would need to crystallise 10% of the entire pension (£80,000). This would leave 90% of your pension uncrystallised.
Your tax-free lump sum does not affect your UK personal allowance.
Which type of pension do you have?
There are two types of employer-sponsored pensions: The defined benefit (final salary) and the defined contribution pension. Defined benefit pensions provide members with a specified amount each year in retirement. Defined contribution schemes differ somewhat from defined benefit schemes. Defined contribution pensions can be funded from both the employee and employer creating a pension with a capital value – overtime this pot can become depleted and run out. Defined benefit pensions are designed to give you an income for life, irrespective of how long you live for.
Defined benefit schemes provide a regular income throughout retirement. This figure is calculated based on the scheme’s accrual rate, your years of service and your final salary amount. This is amount is usually funded in its entirety by the employer.
Defined contribution schemes are more likely to be comprised of both employee and employer contributions. The size of your pension pot will depend on the amount which is contributed. The size of a defined contribution pension is also dependent on the performance of the underlying investments. In theory, if the scheme performs poorly you can receive less back than what you contribute. Defined contribution pensions allow you to take a 25% tax-free lump sum of the pension pot, up to your remaining unused LTA.
Defined Contribution PCLS
As discussed above, the PCLS of a defined contribution can be taken in one go, or can be taken in smaller portions, albeit if the scheme permits this. You can at that point keep the remainder of the money invested within the pension scheme and use flexi-access drawdown to provide an income, or purchase an annuity which will pay a continuous amount until you die.
Defined Benefit PCLS
You can also take a tax-free lump sum from your final salary pension. This involves a calculation which gives you an amount you can take as a lump sum in exchange for a reduced annual amount. Again, with a defined benefit pension once you take a lump sum amount the pension will become crystallised. This calculation depends on the commutation factor for your pension scheme. Whether or not you should take this lump sum depends on your objectives, along with how attractive the lump sum offer is, in comparison to the income which needs to be sacrificed. Taking a lump sum could perhaps give you the purchasing power to buy an asset which could produce an enhanced income, which outweighs the loss incurred from taking the lump sum e.g. a rentable property.