Pension recycling: A little-known trick to generate extra tax relief
Savers making panicked tax-free cash withdrawals ahead of the Budget could fall foul of pension recycling rules if they decide to stick the money back in their pot later, money experts warn.
HMRC could slap a charge of up to 55 per cent of your lump sum if it decides you exploited a little-known trick to generate extra tax relief.
Savers have contacted their pension providers (and This is Money) in droves over fears the Government will tighten the rules on tax-free lump sums in the Budget on 30 October.
Our pension columnist, Steve Webb, answered a reader question just after the election about potential changes to tax-free lump sums and whether taking them ahead of the Budget was a good idea.
However, money experts have warned savers they might come to regret taking tax-free cash ahead of the Budget, because you can miss out on investment growth under the tax protection of a pension in future.
Getting caught out by the pension recycling rules is another consideration to keep in mind, if you are tempted to withdraw tax-free cash before the Budget then put it back if there are no changes after all, because the recycling penalties are so stiff.
‘There are rules in place to prevent people taking out tax-free cash and then reinvesting in their pension, which is known as recycling,’ says Clare Stinton, head of workplace saving analysis at Hargreaves Lansdown.
‘Doing the hokey cokey with your tax-free cash – pulling it out and then putting it back in – could land you with a hefty tax charge.’
How does pension recycling work?
‘Pension recycling is when a person reinvests some, or all, of their tax-free cash, back into their pension to maximise tax-relief,’ explains Stinton.
‘The idea being that by putting the money back into your pension you can generate additional tax relief, and possibly build up fresh entitlement to more tax-free cash.’
She warns there are limits to HMRC’s generosity. This is because you will have received tax relief when contributions were originally made, paid no tax on the withdrawal, and then gone back for more tax relief.
‘This is where they draw the line, and it could be one you unwittingly cross.
‘Limited recycling of tax-free cash is possible. However, if caught on the wrong side of the recycling rules people could end up facing a significant penalty that would likely outweigh any benefit.
‘The tax-free cash will be treated as an unauthorised payment.’ See the box on the right for the penalties.
Stinton adds: ‘Recycling rules only apply to your own pension and do not apply when your tax-free cash is used to boost someone else’s pension, like a spouse’s or child’s pension.’
Meanwhile, bear in mind that when you start tapping a defined contribution pension for any amount over and above your 25 per cent tax free lump sum, you are only able to put away £10,000 a year and still automatically qualify for tax relief from then on.
This rule is designed put people off pension recycling in order to benefit from tax relief twice.
Pension recycling is ‘complex and a bit messy’
Nick Flynn, retirement income director at Canada Life, says: ‘Tax-free cash is widely considered as one of the biggest benefits of a pension, and any changes announced at the upcoming Budget are likely to be contentious.
‘While officially taking some tax-free cash and reinvesting it into your pension to effectively recycle is possible, it is also complex and a bit messy.
‘Getting it wrong could lead to a nasty tax bill.
‘If you are considering such an approach, make sure you check your sums carefully and preferably get specialist financial advice.
‘But you may find the costs and restrictions outweigh the potential advantages. In short, proceed with real care.’
James Jones-Tinsley, self-invested pensions technical specialist at consultancy Barnett Waddingham, says: ‘We have had direct experience of clients withdrawing their tax-free cash ahead of the Budget.
‘However, with the recycling rules in mind, there is also the possibility of a client exercising their cancellation rights under their pension arrangement, within 30 days of doing something with their pension.
‘This could be, for example, withdrawing their tax-free cash sum, effectively reversing what they have done.’
He notes: ‘This would not invoke the recycling rules and potential fines per se, as it is equivalent to pressing an “undo” button – as long as you invoke the cancellation within the statutory 30 -day period.
‘If nothing affecting tax-free cash is announced in the Budget, we are therefore expecting a number of cancellation requests immediately afterwards, and we expect that other pension providers will experience a similar occurrence which clearly has an impact on administration.’
Jones-Tinsley warns that if people take tax-free cash via drawdown as a pre-emptive measure, and this proves to be unnecessary so they try to cancel, they might not get their fees refunded.
‘If they are refunded, it could place a significant financial burden on providers who have already “done the work”, then have to undo it, all for no charge.
‘On the other hand, if refunds are not given, it would amount to a Government-induced tax on individuals, albeit a small one.’
What actions could put YOU on the wrong side of recycling rules
Clare Stinton of Hargreaves outlines three possible scenarios where someone takes tax-free cash, and explains whether they do or don’t break the recycling rules
Pre-empting possible Budget changes
Annie has taken £100,000 tax free cash from her pension as she was worried about the potential for it to be reduced in the Budget.
She has kept it in a bank account while she decides what to do with it.
She thinks that if the change does not happen in the Budget then she will reinvest the whole amount back into her Sipp using carry forward.
Up until this point she has made contributions of £10,000 per year.
If she were to do this then the likelihood is that she would breach the recycling rules.
The amount of tax-free cash taken is more than £7,500. It is a significant increase of more than 30 per cent on her previous contributions and represents more than 30 per cent of the tax-free cash taken.
If it were to be viewed as pre-planned it could be a breach.
Increasing contributions after taking lump sum
Fran takes £150,000 tax-free cash on 1 October 2024 and increases her annual contributions to her workplace pension by £10,000.
This takes her annual contributions from £15,000 to £25,000. Her contributions remain at that level for the next two tax years.
Because the cumulative increase in the value of the total contribution is less than 30 per cent of the tax-free cash taken, the recycling rules have not been broken.
Reinvesting a significant sum in your pension
John receives £60,000 tax-free cash. He plans to use part of the tax-free cash to pay off his mortgage and part to top up his pension.
Over the previous few years, he has been contributing £3,000 a year to his pension.
After paying off his mortgage he reinvests £30,000 in a pension plan.
However, as this investment was pre-planned, it is a significant increase and represents more than 30 per cent of the tax-free cash, it is caught by the recycling rules.