Reclaiming tax on small pension commutations

If you want to cash in a small pension, or several small pensions of up to £17,500 in value during the tax year to 5 April 2010, you may find that too much tax is taken off the lump sum you get.

I will explain how this happens, and what you need to do to reclaim the excess tax.

Cashing in your small pension fund

If you are aged between 60 and under 75 and you have a small pension fund or multiple small funds which you want to cash in. By ‘small’ we mean under £17,500 in total – this is 1% of your lifetime allowance in the 2009/10 tax year, and will increase in subsequent years in line with the lifetime allowance (£ £1.8 million for each year from 2010/11 until 2015/16). The process of cashing in the benefits from a small pension, or a number of small pensions within the £17,500 limit, is known technically as ‘trivial commutation’. It is important to understand that for this to apply - your pension funds from ALL schemes when added together must not exceed the £17,500 limit.

Not all pension scheme providers allow trivial commutation so if you want to take advantage of the new rules you need to contact your insurance company and find out their policy on this.

If you cash in a small pension fund or funds, the first 25% of the lump sum will be tax free, but the remainder will be taxed under PAYE just like wages or pensions are at present. You will have up to 12 months from the date you cash in the first pension to commute up to the £17,500 limit. Bear in mind though that if you are already in receipt of pension income from other schemes, the crystallised pension rights from these schemes will be taken into account when working out whether you will have exceeded the limit.

How to reclaim tax

This is how you should go about claiming a tax repayment if you do cash in a small policy and you think that the tax taken off may be excessive.

When you cash in your policy, your insurance company will send you a form P45. This is the same form as you get when you leave a job. The form shows the amount of the taxable lump sum payment and the PAYE tax taken off.

If you are already receiving a pension from that particular insurance company, they will use your existing code number when they work out the tax due. But if you have not yet started to receive a pension, the company will have to use what is called an emergency code number. This makes it more likely you will have paid too much tax on the lump sum.

Normally HMRC will check your tax position at the end of the tax year and make any repayment due to you then, but if you think you have definitely paid too much tax you can claim an immediate repayment instead of waiting until after 5 April. See below if you complete self assessment tax returns.

If you have any problems getting HMRC to make an in-year repayment I suggest you might quote their own revised manual page to them. The page is PAYE 91045 - taxpayer end of year: taxpayer overpayments: in-year repayments and trivial commutation payments.

To make your claim, you will need to call your HMRC Contact Centre (the phone number will be on your notice of coding or any other correspondence you have had with HMRC) and ask them for a form P53 to complete. If you have had no contact with HMRC in the past you can find phone numbers here or alternatively, in the BT phone book under HM Revenue & Customs (Inland Revenue in older editions). If you are using any other phone company you can still get details from the Yellow Pages under Government Offices.

It is important to note that form P53 can only be issued by your tax office and not by download from the HMRC website or via the Orderline.

You may find that your insurance company will write to you setting out most of the above points when they send you your form P45, but in case they do not, it is worth knowing that you may end up overpaying tax and how to go about reclaiming it.

Self assessment taxpayers - claiming an in-year repayment

For self assessment taxpayers - the option to claim an in-year repayment is available from 6 April 2009.

The form P45 you receive (see above), will ask you to use form P50 to claim a repayment. This form however, will not be appropriate when an in-year payment is requested because you may not be able to sign the relevant declaration. HMRC may want to establish why you think that a repayment is due and in order to do so they will want you instead to complete form P53. This will then provide your tax office with details of your other income. The form can be used either:

To provide estimated details of income, during the year, for early repayment or;

After the end of the year, to check details previously provided. The form is only issued after the end of the year if one has already been issued in year

You can use form P53 despite the fact that the information you give will be estimated for in-year repayments. In any event, HMRC will check the position again after the end of the tax year. You should sign the declaration on the form, and return it along with forms P45 Parts 2 and 3, which are required before any repayment can be made.

You will need to return the form P53 to your main PAYE tax office which is not necessarily the office where your pension/annuity reference is held.

If you are non-resident HMRC will not issue a form P53 as this does not contain enough information to enable them to deal with your claim. You should instead contact CAR - Residency on 0845 070 0040 (or from outside the UK (44) 151 210 2222).

Examples

To illustrate the above I have adapted two articles from HMRC manuals to explain how the new rules work. Trivial commutation is a complicated issue so I have tried to set out each stage of the process for you to look at step by step:

Example 1 – Payment of a trivial commutation lump sum

Kim has uncrystallised (i.e. not cashed in) benefits held under three registered pension schemes A, B and C where each scheme is made up of three arrangements or policy segments (e.g. A1, A2, A3)). The total policies are worth £3,000, £2,500 and £4,000 respectively and Kim’s pension rights are therefore valued at £9,500.

She has no other benefits and is not in receipt of any pension in payment. She also has 100% of her lifetime allowance available - this is £1.75 million for 2009/10 (£1.8 million for the years 2010/11 until 2015/16).

She is aged 62 in the 2010/11 tax year. The rules of all three of her pension schemes allow the commutation of trivial pensions. She has the option of commuting her benefits, as her total pension rights are less than the commutation limit for that tax year (1% of £1.80 million, which is £18,000).

Kim wants to commute her benefits as soon as possible in the 2011 calendar year.

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. The date this first payment is made will be the first day of the 12-month commutation period.

She must draw any further trivial commutation lump from her remaining registered pension schemes before this period ends.

Kim’s pension rights are valued on 1 January 2011. The valuation comes to £9,500. To be a valid valuation, the first trivial commutation lump sum payment must be paid before 1 April 2011 (within 3 months of the valuation).

She 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 in a scheme must be paid as a trivial commutation lump sum, or none of them.

Kim decides to draw all her benefits under scheme A and B as a trivial commutation lump sum. The benefits under scheme A are paid out as a trivial commutation lump sum on 2 February 2011. Her commutation period starts from that date and runs to 1 February 2012.

Any payment from scheme B must therefore be paid by that later date, and that payment must represent all her rights under arrangements B1, B2 and B3.

The benefits under scheme B are paid on 5 March 2011(within the commutation period).

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 2012. But after this date the chance to commute those benefits is lost.

Example 2 – Payment of a trivial commutation lump sum

Mel has uncrystallised benefits held under scheme X, Y and Z worth £1,000, £2,000 and £3,000 respectively on 1 January 2012. She is also in receipt of two pensions from other registered pension schemes, treated as crystallised pension rights, as follows:

From scheme V, a pension of £2,200 per annum, which started in 2003 at the rate of £1,250 per annum and was payable on 5 April 2009 at the rate of £1,600 per annum, and from scheme W, a scheme pension of £1,000 per annum, which started in the 2009/10 tax year at the rate of £750 per annum. At the same time the scheme pension started Mel was also paid a pension commencement lump sum of £2,200.

Mel’s uncrystallised rights are valued at £6,000. Her relevant crystallised pension rights are valued as follows: Scheme V – £50,000 & Scheme W – £20,000

This means Mel’s total pension rights are worth £76,000 (£6,000 £50,000 £20,000) on 1 January 2011).

This is more than the commutation limit of £18,000 at that time (1% of the standard lifetime allowance of £1.80 million for that tax year).

So none of Mel’s benefits under scheme X, Y or Z may be commuted and paid as a trivial commutation lump sum. Nor can her pensions in payment be commuted.