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Pension recycling: A little-known trick to generate extra tax relief
Savers who make panicked tax-free cash withdrawals before the Budget could fall foul of pension recycling rules if they decide to put the money back into their fund later, money experts warn.
HMRC could charge you up to 55 per cent of your lump sum if they decide you took advantage of a little-known trick to generate additional tax relief.
Savers have been contacting 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 October 30.
Our pensions columnist Steve Webb responded to a reader question just after the election about possible changes to tax-free lump sums and whether it was a good idea to bring them forward to the budget.
However, money experts have warned savers they could come to regret taking tax-free cash ahead of the Budget, because in future they may miss out on investment growth under the tax shelter of a pension.
Getting caught out by pension recycling rules is another consideration to bear in mind, if one is tempted to withdraw tax-free cash before the Budget and then return it if there is no change after all, because the recycling penalties are very harsh .
“There are rules in place to stop people taking cash out tax-free and then reinvesting it into their pension, known as recycling,” says Clare Stinton, head of workplace savings analysis at Hargreaves Lansdown.
“Doing foolish things with your tax-free money (taking it out and then putting it back in) could leave you with a significant tax burden.”
How does pension recycling work?
“Pension recycling occurs when a person reinvests some or all of their tax-free cash into their pension to maximize tax relief,” explains Stinton.
“The idea is that by putting the money back into the pension you can generate additional tax relief and possibly create a new entitlement to more tax-free cash.”
He warns that HMRC’s generosity has limits. This is because you will have received tax relief when the contributions were originally made, paid no tax on the withdrawal, and then returned for more tax relief.
‘This is where they draw the line, and it could be a line you cross without realizing it.
‘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 benefits.
“Tax-free cash will be considered an unauthorized payment.” See chart to the right for penalties.
Stinton adds: “The 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, such as a spouse’s or child’s pension.”
Meanwhile, keep in mind that when you start taking advantage of a defined contribution pension for any amount over your 25 per cent tax-free lump sum, you will only be able to save £10,000 a year and still automatically qualify for tax relief from that moment. .
This rule is designed to discourage people from recycling their pensions so they can benefit from tax relief twice.
Pension recycling is “complex and a little complicated”
Nick Flynn, director of retirement income at Canada Life, says: ‘Tax-free cash is widely considered one of the biggest benefits of a pension, and any changes announced in the next budget are likely to be controversial.
‘While it is possible to officially take some tax-free cash and reinvest it into your pension to effectively recycle it, it is also complex and a bit complicated.
‘Getting it wrong could result in a nasty tax bill.
‘If you are considering this option, make sure you check your sums carefully and preferably get specialist financial advice.
‘But you may find that the costs and restrictions outweigh the potential benefits. In short, proceed very carefully.
James Jones-Tinsley, technical specialist in self-invested pensions at consultancy Barnett Waddingham, says: ‘We have had direct experience of clients withdrawing their cash tax-free before the budget.
‘However, taking into account recycling rules, there is also the possibility of a customer exercising their cancellation rights under their pension agreement, within 30 days of doing something with their pension.
“This could be, for example, withdrawing their sum in cash tax-free, effectively reversing what they have done.”
It notes: ‘This would not invoke recycling rules or potential fines per se, as it is equivalent to pressing an “undo” button, as long as you invoke cancellation within the legal 30-day period.
“If nothing affecting tax-free cash is announced in the budget, then we expect a flurry of cancellation requests immediately afterwards, and we expect other pension providers to experience a similar event which clearly has an impact on administration.”
Jones-Tinsley warns that if people take tax-free cash through withdrawals as a preventative measure, and this proves unnecessary and they try to cancel, they may not be refunded their fees.
‘If reimbursed, it could place a significant financial burden on suppliers who have already “done the work” and will then have to undo it, all at no cost.
“On the other hand, if refunds are not granted, it would amount to a government tax on individuals, however small.”
What actions could put YOU on the wrong side of recycling rules?
Hargreaves’ Clare Stinton outlines three possible scenarios in which someone takes tax-free cash and explains whether or not it breaks recycling rules.
Anticipate possible budget changes
Annie has withdrawn £100,000 in tax-free cash from her pension because she was worried about it being cut in the budget.
He has kept it in a bank account while he decides what to do with it.
She thinks that if the change does not happen in the Budget, then she will reinvest the full amount into her Sipp using the rollover.
Up to this point he has made contributions of £10,000 a year.
If you did this, you would most likely violate recycling regulations.
The amount of tax-exempt cash withdrawn is more than £7,500. This is a significant increase of more than 30 percent from your previous contributions and represents more than 30 percent of the cash earned tax-free.
If it were considered something planned in advance, it could be an infringement.
Increasing contributions after receiving a lump sum
Fran receives £150,000 tax-free cash on 1 October 2024 and increases her annual contributions to her workplace pension by £10,000.
This takes your annual contributions from £15,000 to £25,000. Your 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 percent of the tax-free cash earned, the recycling rules have not been violated.
Reinvest a significant sum into your pension
John receives £60,000 in tax-free cash. He plans to use some of the tax-free cash to pay his mortgage and some to supplement his pension.
For the past few years he has contributed £3,000 a year to his pension.
After paying off his mortgage, he reinvests £30,000 into a pension scheme.
However, as this investment was planned in advance, it is a significant increase and represents more than 30 per cent of tax-free cash, and is subject to recycling rules.
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