Uncrystallised Funds Pension Lump Sum
What? Why? When?
Throughout this year in my technical notes, I have looked at various retirement scenarios and pension options, and several times I have mentioned UFPLS (which I still think is the ugliest abbreviation for the tongue-twisting Uncrystallised Funds Pension Lump Sum). What is it? In a nutshell, it is lump sum of money withdrawn from a pension fund. Why is it? It is actually a work-around devised to fix one of those unintended consequences that often crop up when politicians decide to mess around with pensions.
Some background: Until the introduction of the new pension freedoms, what you could withdraw from a pension was limited to the usual 25% tax-free lump sum and then an income of some kind, within certain limits, such as an annuity or via drawdown. With the new pension freedoms came the opportunity to withdraw as much or as little as you like from your pension, even withdrawing the whole lot and closing it down. Therein lies the problem. We need to remember that personal pensions have been around in one form or another for many years and, because of the long-term nature of pensions, there are still many old-style contracts around which were designed in the days when pension legislation was very much more restrictive, and when pension company systems had less computing power than my refrigerator. So these companies faced costly scheme rules re-writes and system upgrades in order to offer the new withdrawal freedoms, costs which would inevitably be passed on to the consumer.
So UFPLS was introduced as a way to allow these older contracts to offer the option of withdrawing the whole fund through a Permissive Statutory Override, which allows them to override existing policy conditions that would ordinarily prevent a complete withdrawal. Permissive, in that companies are permitted to use the override but are not obliged to, so UFPLS may not always be available.
Normal pension withdrawal allows up to 25% to be taken as a tax-free lump sum, so to be consistent, UFPLS is taxed only on 75% of the lump sum; you take one-quarter tax-free, and you pay tax on the remainder. This all sounds quite simple and straight-forward, but beware, there are some bear traps to watch out for.
When a UFPLS is taken the pension administrator has to apply a tax code to the 75% and if they don’t already have one from HMRC they must use an Emergency Month 1 code. This means that all allowances and tax bands are divided by twelve and the withdrawal taxed accordingly. For example, if you have withdrawn £40,000, £10,000 is tax-free and £30,000 is taxable, and the Emergency Month 1 code will assume you are going to be receiving £30,000 every month. If you do this at the start of the tax year, that’s 12 months of £30,000, which is £360,000, which results in quite a large tax bill. Let’s look at the numbers:
|Allowance/Band||Annual||One-twelfth||Tax to pay|
|Basic rate tax band – 20%||£33,500||£2,792||£558.40|
|Higher rate tax band – 40%||£116,500||£9,709||£3,883.60|
|Additional rate tax band – 45%||£198,500||£16,541||£7,443.45|
So that £40,000 withdrawal results in £11,885.45 being deducted at source as tax, and only £28,114.55 being paid out. Under normal rules, assuming the full personal allowance of £11,500 is available, the tax on that £40,000 withdrawal would have been £3,700 giving a net withdrawal of £36,300. The overpaid tax is reclaimable of course, but surely it is inequitable to have been applied in the first place?
So that is bear trap 1. The second trap is the Money Purchase Annual Allowance, which I looked at in my Technical Note in October. I won’t go into detail again (do please go back for a refresher) but suffice to say that, once the MPAA has been triggered, the maximum you can pay into a pension is £4,000 a year. The MPAA is triggered by taking some income under the flexible access rules. I mentioned above that a withdrawal under UFPLS is 75% taxed. That 75% is income, albeit a lump sum of income; but for most people, when you talk of income you think of a regular amount, such as a monthly salary. So the innocent might not think they are withdrawing some income and will be caught out by the MPAA if they use UFPLS.
Bear trap 3 is Inheritance Tax. Some people, whose opinion of pensions are perhaps a little jaundiced, are tempted to withdraw the whole pension fund and reinvest it, in property for example. Bad idea. While money is held in a pension fund it is outside your estate, and therefore shielded from Inheritance Tax. If you take a UFPLS and invest it in property it becomes part of your estate and thus liable to IHT at 40%. Remember that you’ve already paid Income Tax on 75% of the cash and you’re now laying it open to another 40% in tax (not to mention Income Tax on rent and Capital Gains Tax when you sell). Leaving it in the pension where, don’t forget, it is still invested (and in some instances that can include property) keeps it entirely tax-free.
You might think, having read all this, why on earth would you use UFPLS? There is one circumstance when it could be the best option. In most cases, with an old-style pension contract, it is probably best to transfer to a new contract where the whole panoply of options is available. But if you have a relatively small pension fund in one of these older contracts, the costs of advice and transacting a transfer would be disproportionately high. That would then leave you with the only other option being a tiny and uncompetitive annuity. So UFPLS will allow you to take the whole sum and do with it as you wish.
With limited circumstances where UFPLS is a good idea, I would caution against jumping in without at least checking through the other options, and of course we can help with that, though I’m afraid we’re less able to help with issues related to internet-connected fridges.
Philip Chandler APFS, CFPTM, Chartered MCSI
Chair of Aspinalls Technical and Investment Committee