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Individuals entitled to more than 25% tax-free cash

Scheme specific protection is available to pre-6 April 2006 (A-Day) members of occupational schemes (or section 32 buy-out contracts) who had an entitlement to more than 25% tax-free cash from their scheme on 5 April 2006. A scheme member could have more than 25% tax-free cash because, before A-Day, lump sum entitlement for occupational schemes was based on the member's salary and service with the employer linked to the scheme.

A member with more than 25% tax-free cash could have this higher entitlement protected through one of two protections introduced at A-Day:

• Scheme specific tax-free lump sum protection - commonly referred to as 'scheme specific tax-free cash'
• Stand-alone lump sum (for those entitled to 100% of their pension rights as tax free cash)

Before taking benefits, or transferring to another scheme, it's vital to identify individuals who could be entitled to more than 25% tax-free cash so that they don't lose out.

Identifying members with more than 25% tax-free cash

The simplest way to identity these members is to ask the scheme administrator. They may be able to confirm immediately if the member has protected tax-free cash. If not, they may need additional information to calculate A-Day tax-free cash.

To calculate a member's A-Day tax-free cash entitlement, the scheme administrator will need details of the member's salary and bonus history in the years prior to A-Day. The scheme administrator may also ask for details of pension benefits held in other schemes at that time.

Obtaining this historical information can be difficult if the member has not kept records. If this information cannot be found, they may not be able to protect tax-free cash. In this situation, tax-free cash will be limited to 25% of the fund.

Individuals may be entitled to scheme specific protection from several schemes from different employments. These entitlements will be calculated independently of each other. But if they relate to the same employment, the calculation may be different.

Employers with more than one scheme

If someone has benefits in more than one occupational scheme for the same employment, their tax-free cash rights on 5 April 2006 are initially calculated for each scheme separately. If the total tax-free cash for all schemes is within the old HMRC limits for that employment, the schemes with tax-free cash in excess of 25% could be protected. But if the total is more than the HMRC limit, a reduction may have to be applied across each scheme to remove this excess.

The rules on how tax-free cash is allocated to each scheme are complicated and scheme administrators will often need to work with each other to help calculate member's overall tax-free cash entitlement and the entitlement from each scheme.

For more information on this topic please see our Practical Guide – Scheme specific tax-free cash protection - the A-Day calculations.

How the protection works

Members of occupational schemes (including section 32 buy-out contracts) will automatically qualify for scheme specific protection if their lump sum entitlement was more than 25% on A-Day, but it's important to note the following:

• There was no need to register this protection with HMRC - the protected tax-free cash is simply recorded by the scheme administrator. So, it's important that proper records are kept to prove the tax-free cash entitlement on 5 April 2006
• Transfers - the protection is specific to the occupational pension scheme (or section 32) in which the tax-free cash rights were held on 5 April 2006. This protection will normally be lost if benefits are transferred to another pension scheme after 5 April 2006. But it can be maintained in certain circumstances (see below)
• No phasing - the protection will be lost unless all retirement benefits under the scheme are crystallised at the same time - so it's lost if the client uses a phased retirement strategy within the scheme. If drawdown is used, there's no requirement to take any income when the benefits are crystallised.
• Employers with more than one scheme - there are special rules for calculating protection for people who had benefits under more than one occupational pension scheme from the same employment before 6 April 2006
• Enhanced/primary protection - scheme specific tax-free cash protection does not apply to those who registered tax-free cash rights under enhanced or primary protection as these have their own rules
• Stand-alone lump sums - there are separate protection rules for stand-alone lump sums (this is where a person's tax-free cash rights on 5 April 2006 were 100% of the value of the occupational pension scheme for that particular employment)

Scheme specific tax-free cash calculation

The current value of protected tax-free cash is calculated as follows:

1. Determine the member's tax-free cash entitlement on 5 April 2006, and revalue this by 20% 
2. Revalue the A-Day fund value in line with changes to the lifetime allowance by multiplying it by the individual’s LSDBA/£1.5M
3. Deduct the revalued A-Day fund value (see Step 2) from the current fund value, and multiply this by 25%
4. Add the figures from Step 1 and Step 3 together to get the total current protected tax-free cash.

This can be summarised in a formula which, since 6 April 2024, has been simplified to:

(A-Day tax-free cash x 1.2) + 25% of [current fund - (A-Day fund x LSDBA/£1.5M)]

The revaluation of the A-Day fund now uses the individual’s LSDBA as a factor, which is set to the individual’s lifetime allowance (LTA). If they had fixed or individual protection, their LSDBA will be set at their protected LTA. Also, anyone who had an LTA enhancement factor - for example, where on divorce someone received a pension credit from crystallised funds - their LSDBA will be increased by this factor (see our 'Lump sum and death benefit allowance (LSDBA)' guide for examples of this).

Transfers – retaining scheme specific protection

Scheme specific tax-free cash protection will be lost if benefits are transferred to another pension scheme unless the transfer is classed as a block transfer or made as result of a scheme wind-up.

Block transfers

A transfer is a block transfer if:

• Two or more members of a pension scheme transfer to the same receiving scheme at the same time, (although there is no requirement for both members to have protected tax-free cash). The transfer must represent the members' total rights under the transferring scheme and be paid into just one receiving scheme
• In addition, the member transferring must not have been a member of the receiving pension scheme for more than 12 months. This includes all previous periods of membership of the scheme, even if the benefits have since been transferred out. 
  
  A member failing this criterion will not affect the rights of others who transferred under the block transfer.

Scheme wind-up

Tax-free cash protection can also be maintained where an occupational scheme is being wound-up, as long as the trustees either:

• transfer the member's total rights to single deferred annuity contract (or buy-out/section 32 contract), or
• assign the members rights under the scheme into an individual policy directly for the member

Both these options pass the protected cash status onto the 'new' individual contract.

Partial transfers

Scheme specific tax-free cash protection will continue to a limited extent if a partial transfer is made from the protected scheme. There will be no protection for the part transferred out, but the remaining fund will still have protected tax-free cash, reduced by 25% of the transfer value paid.

The additional tax-free cash in the second part of the calculation, associated with the growth since 'A-Day', will also be affected. This is because the current value has been reduced by the amount transferred out. But the 'adjusted value of A-Day rights' will not have changed. Therefore the amount of growth on which tax-free cash is based will also be smaller, or even reduced to zero.

The one exception to this general rule is where a partial transfer is made to comply with a pension sharing order on divorce or civil partnership dissolution. In these circumstances, the protected tax-free cash is not reduced by 25% of the transfer value paid.

Consolidating schemes with scheme specific tax-free cash protection

If someone has two or more schemes with protected scheme specific tax-free cash rights, these cannot be consolidated into the same pension scheme without losing some tax-free cash protection.

For example, an individual is a member of three schemes, A, B and C. All have scheme specific tax-free cash protection. If the order in which they are consolidated into a new plan is A, B and C, then scheme specific protection will be retained by A (because it is the first scheme with protection to be transferred), but lost by B and C. Tax-free cash will still be available from schemes B and C, but will be calculated under the second part of the protected tax-free cash formula.

Remember, an individual must not have been a member of the scheme being used to consolidate for more than 12 months, and the initial transfer must still be done as a block transfer.

Stand-alone lump sums - protecting members entitled to 100% tax-free cash

In addition to the normal scheme specific tax-free cash protection rules, there are special 'stand-alone lump sum' rules.

• Scheme specific tax-free cash qualifies as a stand-alone lump sum if the person's tax-free cash rights on 5 April 2006 were 100% under all occupational pension schemes for that particular employment.
• From 6 April 2023, the tax-free element of the stand-alone lump sum is limited to the lower of the value that could have been paid on 5 April 2023 and (from 6 April 2024) the member's available LSDBA (without any enhancement factors). The amount of the lump sum above that is subject to income tax at the member's marginal rate. 
• Before 6 April 2023, where the stand-alone lump sum rules applied, all of the person's uncrystallised benefits under the scheme could have been paid as tax-free cash on retirement, regardless of the amount of fund growth - as long as certain conditions were met, but if it exceeded the member’s lifetime allowance, the 55% LTA charge would have been levied on the excess.

Losing stand-alone protection

Stand-alone lump sum protection under a scheme will be lost if:

• New benefits (relevant benefit accrual) are built up in the scheme after 5 April 2006,
• Benefits are taken in a phased manner,
• Any benefits are paid as pension, or
• Any transfers are made from or to the scheme, except in the following circumstances:
  
  
  • A block transfer is made to a scheme where the individual isn't already a member, or
  • A transfer is made to or from a scheme which also has stand-alone lump sum rights and all of the member's uncrystallised rights are included in the transfer

The LSA and LSDBA

With the abolition of the LTA from 6 April 2024 came the introduction of two new allowances which limit tax-free lump sums paid from registered pension schemes – the ‘lump sum allowance’ (LSA) and the ‘lump sum and death benefit allowance’ (LSDBA).

The LSA is an overall limit on certain lump sums paid during the member’s lifetime – typically tax-free cash - whereas the LSDBA also includes serious ill-health lump sums and certain lump sum death benefits paid on death before age 75. 

The standard LSA is £268,275 for those without transitional protection.

However, protected tax-free cash under both scheme specific tax-free cash and stand-alone lump sums can be paid even where there is no available LSA. For some individuals, this could mean having to carefully consider the order in which they take their benefits.

However, there is a limit to the tax-free element – it will only be tax-free up to the available LSDBA. Any excess above the LSDBA will be subject to income tax.

Testing against the LSA and LSDBA

For the purpose of testing scheme specific tax-free cash and stand-alone lump sums against the LSDBA, the full tax-free amount paid is always taken into account.

However, it’s a little bit more complicated when it comes to testing against the LSA:

• Scheme specific tax-free cash
  
  Only 25% of the value of benefits crystallised will count towards the individual’s LSA - the excess tax-free cash above that can be ignored.
  
  However, if applying for a ‘transitional tax-free amount certificate’ (TTFAC), the full tax-free amount paid will be taken into account when calculating the LSA deduction in respect of benefits taken before 6 April 2024.
  
  
• Stand-alone lump sums
  
  If the member has registered tax-free cash rights under primary protection, or under enhanced protection where tax-free cash entitlement under all schemes on 5 April 2006 was 100%, then 100% of the tax-free amount paid counts towards the LSA.
  
  Otherwise, only 25% of the value of benefits crystallised will count towards the individual’s LSA - the excess tax-free cash above that can be ignored.
  
  However, if applying for a TTFAC, the full tax-free amount paid will be taken into account when calculating the LSA deduction in respect of benefits taken before 6 April 2024.

Does the order of taking benefits matter?

Protected tax-free cash under both scheme specific tax-free cash and stand-alone lump sums can be paid even where there is no available LSA – so long as it doesn’t exceed the available LSDBA. Any excess above the LSDBA will be subject to income tax.

For this reason, the order in which benefits are crystallised can, for those with large pension funds, impact on the overall tax-free cash available. Taking protected tax-free cash rights last can produce significantly more tax-free cash for some individuals.