Techzone

Scheme specific tax-free cash protection - the basics

Scheme members are eligible for scheme specific tax-free cash protection if they were entitled to more than 25% tax-free cash from their occupational pension scheme (including section 32 buy-out contracts) on 5 April 2006.

If their tax-free cash rights on 5 April 2006 were 100% under all occupational schemes of a particular employer, they could be protected as a 'stand-alone lump sum'. This allowed, subject to certain conditions, all funds to be paid as tax free cash, regardless of growth. However, the Spring Budget 2023 has capped stand-alone lump sums at the value on 5 April 2023.

The simplest way to check the A-Day value of tax-free cash is to ask the scheme administrator. They may have this value, but if they don't they will need to calculate it before tax-free cash is paid to a member or before a block transfer is made to another scheme.

The value is calculated as if the member had taken retirement benefits on 5 April 2006, using the old HMRC maximum benefit rules. You also assume that the member:

• was at an age where they could draw benefits and
• that they left service on that date

For members who left pensionable service before 5 April 2006, their tax-free cash will be valued on the date of leaving the scheme and then revalued to 5 April 2006.

The maximum value of A-Day tax-free cash rights that can be protected is the lowest of:

• the maximum tax-free cash rights calculated using the HMRC maximum benefit formula that applied on 5 April 2006
• the tax-free cash provided under the rules of the scheme
• the total value of the member's benefits under the scheme on 5 April 2006

If the tax-free cash rights are valued at more than 25% of the total value of the member's benefits under the scheme on 5 April 2006, they qualify for protection. If not, the 25% tax-free cash limit applies.

Calculating tax-free cash on 5 April 2006

The old HMRC maximum benefit rules are quite complex and calculations can vary depending on the member's circumstances. There are three methods of calculating tax-free cash and, for most, the method used will depend on the date they joined the scheme.

The following simplified formulas can be used to give an indication of the maximum tax-free cash available under each regime, but scheme administrators should confirm the exact amount of tax-free cash before any action is taken.

Post 1989 members

Maximum tax-free cash is the greater of:

• 3/80ths of final remuneration (limited to the earnings cap of £105,600) for each year of company service, or
• 2.25 x initial pension

When calculating what pension could be provided by the scheme you can either use an assumed annuity rate of £20 per £1 of pension, or an annuity rate from the Government Actuary's Department (GAD) table. However, defined benefit schemes can only use a rate of £20 per £1 of pension.

1987 - 1989 members

Maximum tax-free cash will normally be calculated on the basis of 3/80ths of final remuneration (limited to £105,600 earnings cap) for each year of company service.

For this regime, tax-free cash can be calculated using another more complex formula - the scheme administrator will be able to confirm if this option provides more tax-free cash.

Pre 1987 members

Maximum tax-free cash is the greater of:

• 3/80ths of final remuneration for each year of company service, or
• (N/NS x 1.5 x final remuneration) less any retained lump sum benefits* in other schemes
  
  Where:
  N = Actual service with the employer
  NS = Potential service to the schemes normal retirement date

Pre 1987 members can ignore retained benefits* where P60 earnings from the pensionable employment were no more than £50,000 for the 2004/05 tax year (or, if pensionable employment ended before 6 April 2004, £25,000 for their last complete year of assessment).

* Generally, a retained benefit is a pension benefit built up in respect of an earlier employment/self-employment.

Final remuneration

The definition of final remuneration used in these calculations is the greater of:

• Highest basic pay in a 12 month period within the five years before A-Day or date of leaving service (if earlier) plus the average of yearly 'fluctuating emoluments' (e.g. variable commission, bonus, P11D) over three or more consecutive years
• Highest average salary and fluctuating emoluments over three or more years ending within the 10 years before A-Day, or date of leaving (if earlier)

Note: Controlling Directors and higher earners with remuneration above the 'earnings cap' in definition (1) above can only use the second definition to calculate final remuneration.

For details of how scheme specific protected tax-free cash lump sums are revalued, see our Technical Guide - Scheme specific tax-free cash protection.

Tax-free cash from multiple occupational pension schemes for the same employment

If someone had benefits in more than one OPS for the same employment, their tax-free cash rights at 5 April 2006 under each scheme has to be considered separately to see if they qualified for scheme specific tax-free cash protection.

There's a prescribed method for allocating the tax-free cash rights to each scheme as at 6 April 2006. This method is complicated and can produce unexpected results.

The first step is to work out the tax-free cash rights under each of the connected occupational schemes at 5 April 2006, without taking any account of the other occupational schemes for the same employment. The initially allocated tax-free cash rights to each of the connected schemes is the lowest of:

• the old HMRC benefit limit
• the amount promised under the scheme rules, or
• the value of scheme benefits (e.g. the fund value)

If the total tax-free cash allocation across all the connected schemes is within the old HMRC tax-free cash benefit limit for the employment, that is end of the process. The pre 6 April 2006 tax-free cash rights under each scheme have been identified.

However, it's likely that the initial total tax-free cash allocation across the schemes is more than the old HMRC limit for the employment. In this case, the tax-free cash rights initially allocated to each scheme must be reduced proportionately to remove the excess.

This is done by multiplying the initial tax-free cash allocated to each scheme by a reduction factor. The reduction factor is calculated by dividing:

• the HMRC tax-free cash limit for the employment by
• the total tax-free cash rights initially allocated across all schemes

An example explains how this works.