Tony Wickenden: The big picture on the small pots rule

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This week I am going to continue my look at how an existing pension fund can be used in remuneration planning for a business owner and what, if any, constraints need to be borne in mind when considering this type of strategy.

The mere act of putting a fund into flexible drawdown does not trigger the £10,000 money purchase annual allowance. However, as soon as any “flexible income” is drawn (including drawing an uncrystallised funds pension lump sum) the £10,000 allowance comes into play and remains there. Thus, in the HM Revenue & Customs example quoted in last week’s article, only pension commencement lump sum is taken and no income is drawn.

This is not an exercise where UFPLS would normally be used unless there is carry forward available to mop up any excess over £10,000 in total contributions. However, it is worth noting that, as an UFPLS is not a PCLS, the recycling rules are irrelevant. The recycling legislation in para 3A(1) Sch 29 Finance Act 2004 is couched solely in terms of PCLS.

So can the “small pots” rules be used to generate tax-effective income?

I have already explained that, once minimum pension age has been reached, there are greater opportunities in setting the dividend/bonus/pension mix. In relation to that we looked at using PCLS, but commented that it was also possible to take advantage of the small pots rule. In this article, I will take a closer look at the small pots option.

This option is more limited than using PCLS and will involve some tax but it has three potentially important advantages:

  1. As the non-taxable element of the lump sum payment is not classified as a PCLS the recycling rules are not an issue.
  2. The commutation does not count as a form of flexible access, so the £10,000 money purchase annual allowance is also irrelevant.
  3. A small pots commutation is not a benefit crystallisation event, so there is no testing against the individual’s lifetime allowance – but see below concerning eligibility.

The rules for small pots payments are set out in the Pensions Tax Manual (PTM) 063700. These have changed several times in recent years and can now broadly be summarised as:

  • The individual must have reached minimum pension age (currently 55) or be entitled to take their benefits earlier because they either have a protected pension age or meet the ill-health condition
  • For the lump sum payment to be an authorised payment, the individual must have some available lifetime allowance when payment is made
  • The individual’s benefits under an occupational or public service scheme paying the small lump sum and any related scheme have a total commutation value not exceeding £10,000. For personal pensions the limit is at arrangement level
  • The commutation must extinguish the individual’s entitlement to benefits under the paying scheme, but rights in a related scheme do not also have to be paid as a lump sum
  • For occupational and public service schemes, in the three years before payment, there have been no recognised transfers-out relating to the member, from either the scheme paying the small lump sum or from any related scheme (which in this case includes both occupational pension schemes and public service pension schemes – so long as they are registered pension schemes relating to the same employment as the paying scheme)
  • For occupational and public service schemes the individual must be at arm’s length from any sponsoring employer of the scheme making the payment and any other registered occupational pension scheme which relates to the same employment as the paying scheme. In this context an individual is considered to be at arm’s length if:
  1. They are not a controlling director of the sponsoring employer (in relation to either the paying scheme or any related scheme); and
  2. They are not connected (section 993 ITA 2007) with a person who is a controlling director of the sponsoring employer (in relation to either the paying scheme or any related scheme). This rules out executive pension plans and other occupational schemes established for controlling directors unless they were set up as master trusts with no sponsoring employer (for example, Nest).
  • For schemes other than occupational and public service schemes, that is, primarily personal pensions – no more than three small pots payments may be made. No such limit applies to occupational and public service schemes (the arm’s length proviso is deemed sufficient protection).

In practice, the use of multiple arrangements in many older personal pensions may mean some consolidation will be required to take maximum advantage of the rules. Similarly, where there is one arrangement it may be necessary to subdivide via the establishment of, and transfer to, new arrangements. Some providers will offer this as a service but there are potential adverse consequences if protection is in place. I will next consider an example to close this series.

Tony Wickenden is joint managing director of Technical Connection. You can find him Tweeting @tecconn