When pension freedoms were introduced in the UK in 2015, people were given flexibility on how they could take money from their defined contribution (DC) pension arrangements starting from age 55.
But the government and HM Revenue and Customs (HMRC) did not want people to take a lump sum from their pension and then use it to boost another retirement scheme – also known as pension recycling.
That is because they would exploit a ‘loophole’.
“This artificially increases the value of the pension by taking advantage of an inconsistency in the tax rules,” Thomas Coughlin, retirement expert at Scottish Widows, told International Adviser.
“The lump sum is tax-free but the contribution that is paid back attracts tax relief at the scheme member’s income tax rate.”
Mark Devlin, senior technical manager (pensions) at Prudential, told IA: “If you take your tax-free cash and put it back into a pension, and if you do that a couple of times, you could take it from being effectively 25% to about 35% tax-free cash just by using that lump sum.”
Restrained freedom
As soon as pension freedoms came into effect, pension recycling rules were tightened.
If an individual withdrew their 25% pension commencement lump sum (PCLS), their contributions to a different pension scheme would need to be:
- less than 30% of the lump sum, or
- up to £7,500 if happened after 6 April 2015, or
- up to 1% of the standard lifetime allowance if made before 6 April 2015 – up to £1.5m ($1.9m, €1.7m).
But, if the person withdraws more than the 25% PCLS, their yearly contributions into any other pension scheme will be subject to the money purchase annual allowance (MPAA), which is capped at £4,000.
The limit was initially set at £10,000 but the government lowered it from tax year 2017/18.
If people go over that amount, they would need to pay a tax charge on the excess.
“I think it was brought in because of concerns over a very small number of people – who use recycling as a loophole,” Steven Cameron, pensions director at Aegon, told IA. “But I don’t think that many people have done that.”
Contributions can be made by the individual, by other people on their behalf or by their employer; but they would all be subject to the same rules and limits.
Fitting the criteria
Recycling rules only apply if all of the six conditions set out by the taxman are met.
According to HMRC, pension recycling rules apply when:
- An individual receives a PCLS,
- Because of that lump sum, the contributions paid into a registered pension scheme is significantly greater than otherwise it would be,
- The additional contributions are made by the individual or by someone else,
- The recycling was pre-planned (but it would be for HMRC to prove premeditation),
- The amount of the PCLS, together with any other lump sum taken in the previous 12 months, exceeds either £7,500 (for events on or after 6 April 2015), or 1% of the standard lifetime allowance (for events before 6 April 2015), and;
- The cumulative amount of the additional contributions exceeds 30% of the lump sum.
“There are, effectively, six rules and as long as you can actually discount one, you should be okay,” Devlin added.
But you can still fall foul of the recycling rules at a later date.
The statute of limitation runs two years prior and after the PCLS was taken, which makes a five-year window when also including the tax year in which the withdrawal took place.
People can still maximise
“The rules are not there to stop clients maximising their pension savings in the run up to retirement, and that limited recycling of tax-free cash may be possible without triggering a tax penalty,” Dave Downie, technical consultancy manager at Standard Life, told IA.
However, Fiona Hanrahan, business development manager at Royal London, doesn’t see any positives in recycling.
She told IA: “The benefit would be that you’re removing something from being crystallised to un-crystallised. But the maximum that you would be able to put back in is capped at £4,000, due to the MPAA.
“To me it’s more about people using the maximum allowances possible.”
Awareness and planning are essential
“We worry that there will be people out there, who have hit 55, have got a small pension, or a relatively modest pension, and thought ‘let’s just cash this one and I don’t really need this one, I’ve got some others which I’m still contributing to’,” Cameron added.
“If they cash that one in, and go beyond taking 25% tax free cash, then that will be deemed as having used the pension freedoms and suddenly the subject to the MPAA. So that, to me, is the biggest concern.
“The main thing we need to do is to get out the message that for anyone who uses pension freedoms there are consequences, and one consequence is that you’re limited; you and your employer can’t put more than £4,000 in any year.
“People are working much longer nowadays. So, age 55 is a very young age to be taking anything out of your pension. And I think we need to encourage people to not see that as the default.
“We really need to try to encourage people to only depend on their pension when they actually need that money. Providers offer risk warnings, but [pension recycling] can come back to haunt them.”
That is why Devlin believes that, as soon as people start thinking about recycling or anything similar to it, they need to seek advice.
“It’s probably not a bad idea when you’re getting towards your retirement anyway, to have somebody else check over where you are and what you can potentially do.”
When do recycling rules apply?
To understand the complexity of pension recycling, HMRC has provided case studies to understand how people could breach the rules.
There are five main scenarios where pension recycling rules apply.
These are:
- If the entire lump sum is used as a contribution to a pension scheme,
- If lump sum contributions are made at different times, they would still count as an aggregate contribution,
- If the contribution is taken from other resources available (such as savings) and then the individual uses the lump sum to replenish them,
- If the contribution is significantly increased based on average annual calculations,
- Or if there is a ‘salary sacrifice’ type of arrangement where the contribution is significantly higher than it would have been.
When do they not apply?
However, there are also exceptions to the examples above, when pension recycling rules are not enforceable.
For instance:
- If a contribution is significantly higher because of a change in employer,
- If contributions paid into a scheme are on the same basis, but fluctuate with salary levels,
- If a person hasn’t contributed to their pension scheme for a few years and then they pay in a lump sum, the value of the latest contribution will be adjusted according to the Retail Price Index to calculate the equivalent value,
- If cumulative contributions do not exceed 30% of the original lump sum,
- If contributions are based on the profits from self-employment,
- Or if, after withdrawing a lump sum, a substantial contribution is paid in after winning a lottery, with the amount paid in being either less or equal to the winning. The same applies to inheritance or financial settlement.
