In this article written for the summer edition of Envoy Magazine, we describe the choices that may well have to be made about lump sums and their implications on transitioning.
The lump sums and the options – which are irrevocable once taken – are as follows:
- AFPS 75 provides an automatic tax-free lump sum of three times the pension. Those leaving with an Immediate Pension (IP) having given 22 years Reckonable Service (RS) after age 18 as an Other Rank or 16 years RS after age 21 as an Officer can choose to buy another lump sum and pay for it from their pre-tax pension between their retirement and age 55. This is known as Resettlement Commutation and can be tax-efficient as it reduces ‘earned income’. This is not available to those leaving with an invaliding pension.
- AFPS 05 provides an automatic tax-free lump sum of three times the pension. It is payable on discharge with an ill-health pension, discharge at or after age 55 or age 65 if discharged before age 55 and, when payable, individuals may choose to give up some or all of this lump sum to improve their taxable pension. This is known as inverse commutation (IV). IV may increase the member’s tax bill as it increases ‘earned income’.
- The AFPS 05 EDP scheme provides an automatic tax-free lump sum normally worth three times the pension. To qualify, individuals must have given at least 18 years’ service and must be at least age 40. There are no options in respect of this lump sum.
- AFPS 15 does not provide an automatic pension lump sum. The pension is payable on discharge with an ill-health pension, on discharge on or after age 60 or at state pension age, if discharged before age 60 and, when it is payable, any member can commute – that is they may generate a tax-free lump sum by surrendering pension. Commutation may have the effect of reducing tax liability as it reduces ‘earned income’.
- The AFPS 15 EDP scheme provides an automatic tax-free lump sum of 2.25 times pension. To qualify, individuals must have given at least 20 years’ service and must be at least age 40. The whole EDP lump sum – all or nothing – can be surrendered to improve their EDP income which may increase tax liability by increasing ‘earned income.
Most Servicemen and women have entitlements in more than one scheme, having been transferred to AFPS 15. I will use the example of Sergeant Freddie Fox to illustrate the benefit choices that need to be made in such cases.
Freddie joined on 1 April 1998 and he is to be discharged on 31 March 2020 at age 40 (exactly 22 years’ service). His final pensionable pay (FPP) is £40,000. His AFPS 15 benefits and choices would be:
An AFPS 15 pension, payable at state pension age, based pensionable earnings since 1 April 15. Taking account of earlier rates of pay and incorporating the Earnings Index, his pension would be £4,198.44. When he comes to claim this pension he can choose to commute to generate a lump sum – rule of thumb: £1 surrendered generates £12 tax free. To calculate the maximum lump sum he can generate:
Multiply the pension by 20 and divide by 56 = £1,499.44
Multiply £1,499.44 by 12= £17,993.28
The remaining pension would be (£4,198.44 – £1,499.44) £2,699.
An AFPS 15 EDP tax-free lump sum of £9,446.49(2.25 x pension) and an annual EDP income of £1,427.47 (34% of pension) payable until state pension age, with CPI increases applied at age 55. If he gave up the EDP tax-free lump sum his taxable EDP income would increase by £542.44 per year.
Had he been an AFPS 05 member before 1 April 2015, he would be entitled to the following:
AFPS 05 pension and lump sum, preserved until age 65. The pension would be FPP x RS in AFPS 05, divided by 70 (£40,000 x 17/70 = £ 9,714.29). The tax-free lump sum would be £29,142.87. When he claims this pension, his IV choice is that for every £100 of his tax-free lump sum he gives up, his taxable pension will improved by £6.10 per year. So, if Freddie surrendered the whole of his tax-free pension lump sum his taxable pension would increase by £1,777.72.
An AFPS 05 EDP tax-free lump sum of £29,142.87 and an annual EDP income of 50% of his the value of his AFPS 05 pension, rising to 75% at age 55 plus CPI increases. Freddie has no choice to make in respect of this EDP lump sum.
Had he been an AFPS 75 member prior to 1 April 2015, he would be entitled to the following*:
An AFPS 75 IP of £8,919.06, which is 17/22nds of the 22 year rate for a Sergeant. The tax-free lump sum is £26,757.18. The most he can commute is the difference between the 22 year lump sum for a Sergeant (£33,948) and the lump sum for a Sergeant with 37 years’ service (£51,723) – so £17,775. So, if Freddie took the whole £17,775, his pre-tax pension would be reduced by £1,714.40 per year (£96.45 per £1,000) until age 55 when his pension will be restored to its original level and increased by CPI. The cost per £1K is based on his age on discharge the full table of costs is at Annex B HERE
You will pay back more than you borrow but, if you are a 40% tax payer, the cost may well be totally off-set by the saving on tax.
*We have used the 2018/19 Pension Code + an assumed 2% rise for 2019/20
You can see the article here in PDF format – turn to page 30/31
Top Image: Service personnel at a meeting in MOD Main Building in London. Contains public sector information licensed under the Open Government Licence v3.0