Pension recycling – risks and opportunities

Many advisers will be aware that you can’t re-contribute tax-free lump sums back into a pension. However, it’s worth noting that this rule doesn’t apply to all lump sums or to all pension payments. This article will look at the risks and the opportunities of paying pension money… back into a pension

Whenever a client asks about taking a tax-free lump while increasing their pension contributions, advisers will understandably be nervous about entertaining this line of enquiry.

The reason being that if a pension scheme member were to take their tax-free Pension Commencement Lump Sum (PCLS) and pay it back into their pension they would fall foul of the recycling rule. The PCLS could then be deemed an unauthorised payment and attract significant tax charges for the member and their pension: charges that would greatly outweigh the benefit of the tax relief.

While the caution is understandable, there may still be scope to make contributions, so it’s worth looking at the rule in more detail.

How does the legislation define recycling?

For HMRC to challenge a PCLS, the following conditions must all apply.

Of these conditions, the 30 per cent point is the most interesting. Strictly speaking, it’s an HMRC rule of thumb rather than written into legislation, so it’s perhaps not advisable to push right up against it. However, it’s notable because it does still allow a fairly significant increase in additional contributions, which is often overlooked.

Another key point is that the rules only refer to PCLSs, and there is no mention of pension income or other lump sums (e.g. uncrystallised funds pensions lump sums (UFPLS)). Therefore, if a client wanted to pay pension income back into a pension, they would not get caught by the recycling rule.

They would need to be aware that if the pension income was coming from a flexi-access drawdown fund, the income would trigger the money purchase annual allowance (MPAA), meaning their annual allowance would drop from £40,000 to £4,000, so they’d be limited in how much they could pay back in. They would also need to bear in mind that they would be paying Income Tax on withdrawals.

However, let’s say the pension income was from a beneficiary’s drawdown fund where the original member died before age 75. Income from a beneficiary’s drawdown doesn’t trigger the MPAA, and the income would be tax-free, so there could be some logic in funnelling it back into the scheme. The downside is that the newly contributed funds would then be subject to the lifetime allowance when they’re eventually accessed.

And with any of these scenarios, remember that the client must have taxable UK earnings in the current tax year in order to get tax relief on the contribution.

How do you assess the risk?

While the official guidance from HMRC is helpful, there are no known cases from the tax tribunals or the courts to illustrate how HMRC pursues this in practice. It’s also worth noting that pension scheme administrators are not required to monitor or report potential recycling infractions: the onus is on HMRC to detect it.

However, if a client were to take a PCLS of £100,000 and then immediately start making additional monthly contributions of £1,500, for example, they would seem to be at a high risk of being pursued. £1,500 paid monthly over three years comes to more than 30 per cent of the PCLS, and on the face of it there’s a direct link.

However, let’s say the client was made redundant and took the £100,000 PCLS to pay off their mortgage. Three months later, they get a new job, and with their previous outgoings now much reduced they are able to make additional regular contributions of £1,500 each month.

In that second scenario, the two events – PCLS and contribution increase – happened independently and are only loosely connected. More importantly, they weren’t pre-planned, so it would seem very unlikely to be challenged.

If you were to come across a situation that did feel a bit too close for comfort, one option is to make pension contributions for family members. These would not be caught by the recycling rule, and it would still achieve the same overall effect of using the lump sum to gain further tax relief, albeit for the family as a whole.