RPSM09105150 - Technical Pages: Member benefits: Lump sums: Winding up lump sum: Taxation

Taxation of the winding-up lump sum

[Para 11, Sch 31][s636B, Chapter 15A, ITEPA 2003][Para 59, Sch 10, FA 2005] 

A winding-up lump sum is taxed on the member in exactly the same way as a trivial commutation lump sum.

If the member has not previously drawn (or become entitled to) any other benefits under the registered pension scheme before the winding-up lump sum is paid 75% of the lump sum paid is treated as taxable pension income of the member for the tax year the payment is made, accountable through PAYE.

A 25% deduction is given to reflect that if normal benefit rules applied, the member would generally be entitled to a tax-free pension commencement lump sum, representing 25% of the capital value of the benefits coming into payment. No extra deduction is given where the member is entitled to a pension commencement lump sum of more than 25% due to the transitional protection of such an entitlement held before 6 April 2006.

Where the only rights under the registered pension scheme that are commuted represent a pension in payment, all of the winding-up lump sum is treated as taxable pension income of the member for the tax year the lump sum payment is made. This taxable income is accountable through PAYE.

Where the rights under the registered pension scheme represent both a pension in payment (or any other rights the member has become entitled to or a mixture of both) and uncrystallised rights in respect of the member, credit is given for any pension commencement lump sum that potentially could be drawn from those uncrystallised rights held in any arrangement under the scheme. In this circumstance, 25% of the value of the uncrystallised rights may be paid tax-free, with the remaining part of the payment being treated and taxed as pension income for the tax year the lump sum payment is made. Again, this taxable income is accountable through PAYE. RPSM04104670 explains how we value uncrystallised rights for these purposes.

Operating PAYE on the payment

Where the lump sum payment is in respect of a pension already in payment, use the PAYE code already in operation. Where the member’s pension has not yet been paid and the scheme does not have a PAYE code for the recipient an emergency code applies.

Guidance on how to operate PAYE correctly on these lump sums can be found in CWG2 - Employer’s further guide to PAYE and NICs. A copy of the CWG2 can be found on the HMRC website. To find it on the HMRC website either use the ‘find a form’ function or type CWG2 into the ‘search’ box at the top of the HMRC webpage.

There is also guidance for pension schemes on how to operate PAYE on the HMRC website at http://www.hmrc.gov.uk/paye/payroll/pensions. This includes guidance on how to operate PAYE on winding up lump sums.

Because of the way PAYE works on these lump sum payments often the member ends up paying too much tax. Where this happens, the member can claim the tax back in year. There is guidance for individuals on how to do this on the HMRC website at http://www.hmrc.gov.uk/incometax/overpaid-thro-pension.htm. The problem is that many of the people affected won’t know that they may have paid too much tax and so are entitled to a tax refund. To help the people affected please include advice on how to claim a refund when you issue the lump sum payment. There is some suggested wording that you could use shown below. This will also help you by reducing the number of enquiries you may get on how the lump sum has been taxed and claiming refunds.

Suggested wording pension payers can use when making the lump sum payment

Your form P45 details include the amount of tax deducted from your pension commutation lump sum. The tax deducted may not be the right amount due when all of your income for the year is taken into account.

After next 5 April HM Revenue & Customs will check if you have paid the correct amount of tax, and if not they will contact you. But if you think you have paid too much tax you can ask HM Revenue & Customs for a tax refund now - you do not have to wait until 5 April.

To claim a refund call your usual Revenue & Customs office and ask for form P53. You can find the numbers on the ‘contact us’ pages of the HMRC website at www.hmrc.gov.uk, or alternatively, in the phone book under HM Revenue & Customs.

It helps if you have your National Insurance number to hand when you call.