Cashing in small pensions and bigger pensions

In some situations it is possible to turn small pensions into a cash lump sum rather than drawing them as income. There are also ways to turn bigger pensions into cash, but watch out for scams.

At retirement

When you want to start drawing a pension from an occupational pension scheme or personal pension, you can usually take a quarter of your savings as tax-free cash (sometimes called a pension commencement lump sum or PCLS). The rest must be drawn as a pension.

But in some situations, you can take the whole of your pension savings as a cash lump sum. This can seem attractive, if you have debts to pay off, want to make a large purchase or want more control over your money.

Turning small pensions into cash

If your pension savings are low, they will not buy much pension and you may have problems finding a provider willing to pay out only a small amount of income.

To avoid this problem, if your total pension savings (across all the pension schemes you belong to) come to no more than £18,000, you are allowed to draw the whole lot as a lump sum. This is called ‘trivial commutation’.

In addition, small pensions in an employer’s occupational pension scheme that are equivalent to no more than £2,000 as a lump sum (regardless of any other retirement savings you have) can also be drawn out in full as a lump sum.

From 2012-13, the government has proposed that the £2,000-rule be extended to personal pensions as well. This means that, where the value of the fund you have in a personal pension is no more than £2,000, you will be able to take the whole lot as cash. To prevent you artificially splitting a larger plan into many smaller personal pensions, you will only be able to use this option twice.

A quarter of the amount from turning small pensions into a lump sum is treated as tax-free cash. The remainder is taxed as income.

To explore your trivial commutation options, contact your HR department at work in the case of an occupational pension scheme or the provider for a personal pension.

If the lump sum is paid through the PAYE system, your income for that pay period will look unusually high and too much tax might be deducted. In that case, you will need to contact HM Revenue & Customs (HMRC) to claim tax back.

Using the income drawdown rules

With many pension schemes, you reach retirement with a pension fund that you need to turn into income. Often the best way to do this is to buy a lifetime annuity. This is an investment that turns a lump sum (such as your pension fund) into an income for life.

Another option is to use income drawdown. This means that you leave your pension fund invested and periodically cash in part of the fund to provide your income.

Since 6 April 2011, new income drawdown rules apply. Provided you have at least £20,000 a year of retirement income from dependable sources, such as pensions from the State, an occupational scheme and/or lifetime annuities providing level or increasing income, you can opt for ‘flexible drawdown’ for the rest of your pension savings.

With flexible drawdown, you choose when, how often and how much of your pension fund you want to cash in. So you can use this part of your savings to provide you with one or more cash lump sums as and when you want. These are taxable as income for the year you take them.

If your savings are currently in a scheme that does not allow you to use income drawdown, you could transfer the savings to another scheme that does. Be wary of transferring out of an occupational pension scheme if this means giving up a generous pension.

Using the income drawdown rules is a complex area, so consider getting help from an independent financial adviser.

Scams and deals to avoid

Normally, you cannot start to draw a pension from an occupational pension scheme or personal pension until you reach age 55.

From time to time, ‘pension liberation’ (also called ‘trust busting’) deals come onto the market, promising to convert your pension savings into cash before 55. Most of these are illegal scams. Avoid them! The liberators will take a large chunk of your savings as ‘fees’ and you will also be liable to pay tax and penalties to HM Revenue & Customs.

A few such deals aim to exploit tax loopholes and claim to be legal. But HM Revenue & Customs is generally quick to challenge such schemes and close the loopholes. In the meantime, you are likely to find a large chunk of your savings disappearing in fees to the firm offering the deal.