A misunderstanding of the way tax free cash can be taken from a pension could cost customers a tax charge of up to 70%.
Scottish Equitable reveals it is receiving a number of queries to its technical services area on whether the company will accept a pension fund transfer after the member has received a pension commencement lump sum (PCLS) or tax-free cash.
These queries suggest people believe once the PCLS has been paid the remainder of the funds is left in a pot with the ability to switch to another provider if required to move into an unsecured pension (USP).
But Scottish Equitable says this would be a potentially serious breach of legislation as its understanding of the rules, which has been confirmed by HM Revenue and Customs (HMRC), suggests once tax-free cash has been paid, the remainder of the funds has to be used to purchase an annuity through the Open Market Option (OMO) or to move into USP.
Rachel Vahey, head of pensions development at Scottish Equitable, says the number of enquiries might be because people want to go into USP, but it is not something which their current scheme offers.
She warns if this is the case, the only option is to transfer the whole pension fund to another provider who offers USP before the PCLS is paid otherwise the member could be subject to an unauthorised payment charge of up to 70%.
If a scheme pays a member 25% tax-free cash and doesn’t immediately convert the remaining funds into an annuity or USP, this becomes an unauthorised payment and is charged at 40%.
In addition, if the amount of the unauthorised payment is 25% or more of the total fund, which when dealing with PCLS is very likely as most people will take the maximum amount available of 25%, then this results in a scheme sanction charge of 15%.
Then if it can be proved the administrator paid out the PCLS when it shouldn’t have, there is an additional scheme administrator charge of 15% which Vahey says in most cases the provider will seek to pass on to the individual, resulting in a possible total charge of 70%.
As a result, Vahey says Scottish Equitable has turned away potential business over this issue on the basis not only would it be a breach of the rules, and the administrator would be responsible for trying to retrieve the tax charges, but also because the client should not have to suffer any unnecessary tax charges.
Having confirmed the rules with HMRC, Scottish Equitable says it is now liaising with its counterparts in other life offices to make sure everybody takes the same line, as it seems the legislation isn’t being properly understood by the general market.
Vahey says: “This is an exercise in working together, and most of the technical people we’ve spoken to at other life offices have agreed they interpret the legislation in the same way as us, but somewhere down the line something is obviously going amiss.”
She points out the tax charge is quite a hefty amount, and it is worrying there could be lots of people considering this move and not appreciating it is classed as an unauthorised payment.
“Pensions simplification has been anything but and it is inevitable there will be teething problems while we all get used to the new regime. But this is a particularly worrying misunderstanding which has come to light as anyone doing it is storing up serious tax charges for the future,” says Vahey.
“It is important we get industry wide clarification of the correct procedure as soon as possible.”
Colin Batchelor, head of pensions technical at Legal & General, says as a general rule benefits should be taken at the same time as the tax free cash.
He says: “We have only had one request for this, but we’ve had to turn it down because it is simply not allowed. It seems it’s mainly people from occupational schemes which offer higher PCLS but not USP.”
As a result, he says people want to take the maximum amount of tax-free cash and then try to transfer the remaining funds into another scheme to gain access to USP, but this could trigger an unauthorised payment charge as you can only transfer into USP from another USP contract.
Batchelor warns there may be some companies who are "trying to be a bit clever" and try to get round the rules by allowing people to take the PCLS and then moving the remaining funds from say an executive personal pension into some kind of holding fund which is classed as a drawdown vehicle, despite the company not offering drawdown.
He says in theory they can then transfer the funds into another USP contract legitimately as a USP to USP transfer without incurring any penalties. But Batchelor says it is more likely most companies would refuse the transfer.
He adds: “We haven’t had many requests for this, but if the correct procedure hadn’t been followed we would have to turn them down. It seems to be a case of people trying to have their cake and eat it.”
And Maureen Duckworth, pensions technical manager at Scottish Life, says although it is possible to take a PCLS then buy an annuity through the OMO, you can’t do the same thing with USP.
She says: “You cannot take PCLS from one scheme and then transfer the balance of the funds into another to take advantage of USP. This is an unauthorised payment and tax charges would apply.”
“We have received questions asking for clarification on this and have had to advise that it's just not allowed under the rules,” adds Duckworth.
Meanwhile, HMRC says the interpretation by the life companies is correct, as under the tax rules, for a tax-free lump sum to be payable, it must be paid in connection with a relevant pension.
Georgina Myles, spokeswoman for HMRC, says: “If a registered pension scheme is merely paying a lump sum with no entitlement to pension under the same scheme and the rest of the funds are transferred this may lead to the lump sum being an unauthorised payment, and being taxable accordingly.”
Although she says the amount of tax will depend on the facts of a particular case, and if there is an unauthorised payment, it will only affect the pension scheme paying the lump sum it will have no effect on any scheme which receives a transfer.
Myles adds: “This issue will be included in the registered pensions schemes manual (RPSM) which is being revised following the enactment of the Finance Bill 2006. This will be published in the near future.”
If you have any comments you would like to add to this story or would like to speak to its author about a similar subject, telephone Nyree Stewart on 020 7968 4558 or email [email protected]IFAonline
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