25% of the lump sum is payable tax-free. The rest is payable at the member's marginal rate of income tax. This means that if they currently pay tax at the 20% basic rate tax then 75% of the lump sum will be subject to this tax, unless the lump sum payment pushes them into a higher tax bracket. For example, if somebody has a lump sum of £10,000 then they will receive £2,500 tax-free and £7,500 will be subject to 20% tax. This means that, in this example, in total they will be entitled to a lump of £2,500 plus £6,000 after tax, being a total of £8,500.
The provider or scheme trustee is required to apply tax at the basic rate regardless of the amount of tax the member is actually liable for. This means that the amount of tax the provider or scheme trustee deducts may be greater or less than the amount which should apply to the member. If the member thinks that they have paid too much or not enough tax then they will need to discuss this with HMRC.
It is important to be aware that taking lump sums from the pension in this way could push the member into a higher income tax bracket, which could mean that they need to pay more tax than they originally thought.
When the small pot rule is being applied to crystallised funds, the entire lump sum will be taxed as income at the marginal rate.
HMRC Pensions Tax Manual - PTM063500: Trivial commutation lump sum - Taxation (opens in a new window)
HMRC Pensions Tax Manual - PTM063700: Small pension payments - Taxation (opens in a new window)