The Taxing issue of Small Pots

I was recently asked a question about the taxation of ‘Small Pot’ commutations.

By way of background, Aries recently updated its guidance to reflect the changes introduced under the Finance Act 2024 .

As part of this, we expanded our guidance on the taxation of ‘Small Pot’ commutations and one of our members asked whether there had actually been any changes in the taxation basis here.

‘Small Pots’ were introduced under Regulations 11 – 12 of The Registered Pension Schemes (Authorised Payments) Regulations 2009 [SI 2009 / 1171 ]. (Note that Regulation 11A was also inserted, with effect from 6 April 2012 by [SI 2012 / 522 ].)

Regulation 3 of SI 2009 / 1171 says (and always had said) that:

A payment by a registered pension scheme to or in respect of a member that is described in Part 2 of these Regulations [which includes ‘Small Pots’] —

(a) is a payment of a prescribed description for the purposes of section 164(1)(f) (authorised member payments);

(b) if paid to the member, shall be treated as a trivial commutation lump sum paid to the member for the purposes of Part 9 of ITEPA 2003 (pension income);

…

So, ‘Small Pots’ have always been taxed as though they were trivial commutation payments.

Before 6 April 2024, this taxation basis was detailed in Section 636B of the Income Tax (Earnings and Pensions) Act 2003 (‘ITEPA 2003’). This said that, where a trivial commutation payment is made to a member:

(2) The member is to be treated as having taxable pension income for the tax year in which the payment is made equal to the amount of the lump sum.

(3) But if, immediately before the lump sum is paid, the member has uncrystallised rights under any one or more arrangements under the pension scheme, the amount of the taxable pension income—

(a) if all his rights under the pension scheme are uncrystallised rights, is 75% of the lump sum, and

(b) otherwise, is reduced by 25% of the value of any uncrystallised rights extinguished by the lump sum.

…

(5) In this section “uncrystallised rights” has the same meaning as in section 212 of FA 2004; and the value for the purposes of this section of any uncrystallised rights is to be calculated in accordance with that section.

When the Finance Bill 2024 was published, this repealed Section 636B of ITEPA 2003 and introduced a new draft Section, Section 637G, which – as originally drafted – said that, where a trivial commutation payment is made to a member, the member:

… is treated as having taxable pension income for the tax year in which the payment is made equal to the amount of the lump sum.

(2) If, immediately before the lump sum is paid, the member has uncrystallised rights under any one or more arrangements under the pension scheme, the amount of the taxable pension income is reduced by the tax-free element (if any).

(3) In subsection (2) "the tax-free element" means 25% of the value of any uncrystallised rights extinguished by the lump sum.

(4) In this section "uncrystallised rights" has the same meaning as in section 212 of FA 2004; and the value for the purposes of this section of any uncrystallised rights is to be calculated in accordance with that section.

It may not be instantly obvious, however the impact of the draft wording was rather different from that of the old Section 636B. Crucially, Section 636B included the provision that:

if all his rights under the pension scheme are uncrystallised rights, [the taxable amount] is 75% of the lump sum

This was, however, missing from the original version of Section 637G. The practical impact of this would have been that, even where only uncrystallised rights are involved, the ‘section 212 of FA 2004’ valuation basis would have had to be used to determine the value of the uncrystallised rights involved (and thus the tax-free element).

Fortunately, this oversight was corrected by Regulation 2 of The Pensions (Abolition of Lifetime Allowance Charge etc) Regulations 2024 [SI 2024 / 356], so that Section 637G (2) reads:

(2) If, immediately before the lump sum is paid, the member has uncrystallised rights under any one or more arrangements under the pension scheme, the amount of the taxable pension income —

(a) if all the member's rights under the pension scheme are uncrystallised rights, is 75% of the lump sum, and

(b) otherwise, is reduced by the tax-free element (if any).

This restored the status quo and ensured that, where the entire ‘Small Pot’ represents uncrystallised rights, the tax-free element of the Small Pot is simply 25% of the amount of the Small Pot, with no reference to the ‘section 212 of FA 2004’ valuation basis.

As such, we could confirm to our enquirer that there had, in fact, been no changes here.

Finally here, it is worth noting that, where only part of the ‘Small Pot’ is paid from uncrystallised rights, the taxable element of the ‘Small Pot’ is the total amount paid minus 25% of the value of the uncrystallised rights. This is particularly relevant where defined benefits are involved, as the tax-free element is not simply 25% of the amount of the ‘Small Pot’. Instead, it is the amount calculated in line with Section 212 of the Finance Act 2004, as explained in the PTM .

Aries Insight ?provides comprehensive and detailed guidance on the application of the new tax rules, as well as insight into the meaning and impact of UK pensions regulation and clear guidance on the practical implications for pension providers, trustees, administrators and consultants.? If you are not already an Aries member and would like to find out more about what Aries Insight can offer you, then please drop me a mail at [email protected] or give me a call on 01536 763352.

Please note that?we are not lawyers or financial advisers.?The information above sets out our best understanding of the legislation and how it applies, but should not be taken as constituting legal or financial advice.