Nicholas Watts: Beware the dangers of pension recycling
Nowadays we are encouraged to recycle everything from paper to tin cans, to bottles and every sort of electrical appliance.
However there is one type of recycling that should be treated with a great deal of care.
I refer specifically to the tax-free lump sum that you can take whenever you cash in your pension scheme.
The practice of recycling this involves taking your lump sum and, immediately after receipt, using it to make a new pension contribution on which you will receive tax relief.
Sound too good to be true? Then it will be no surprise to know that HMRC are very unhappy with the practice.
Also, like all pension matters, it is not quite as straightforward as it looks and is restricted by many an ‘if’ and ‘but’. The problem is how do you know if you have broken the rules?
HMRC sets out five conditions, all of which must be met for recycling to apply.
1. Tax-free cash has to have been taken from a scheme in the last 12 months.
2. The total of all tax-free payments in a 12-month period has to be over 1% of the standard lifetime allowance. This equates to £16,500 in the 2008/09 tax year.
3. Any contributions by whosoever has to increase by 30% of what might have been expected. For the purposes of this condition, contributions in five tax years need to be considered.
The specific tax years are the ones in which the tax-free cash is taken, the two tax years before and the two after.
4. There is a contribution increase to all pension schemes of more than 30% of the tax-free cash payments.
5. The recycling is pre-planned. This means that there was always the intention to increase pension contributions significantly as a result of taking tax-free cash.
Of course timing is important and a couple of simple examples might help. Mr X, having taken one tax-free amount — say £10,000 — in a particular year, takes another £10,000 payment – maybe as a result of phased retirement planning.
He had been paying £4,000 per annum into the scheme. In this case Mr X would trigger the recycling penalties because he pre-planned it and the total of the tax-free cash was more than 1% of the standard lifetime allowance. The contribution £10,000 is greater than the 30% of the tax-free cash and finally the contribution has increased by more than 30% of the £4,000 which Mr X was paying.
Hey presto, all of the conditions have been met and the second payment is treated as an ‘unauthorised member’ payment. So what happens when HMRC deems a payment to be an Unauthorised Member payment? There are a number of penalties that HMRC can apply:
- A tax charge of 40% of the tax-free sum paid
- An Unauthorised Payment surcharge of 15% on top
- A scheme sanction charge of 40% of the tax-free sum paid
- A de-registration charge of 40% of the total scheme assets.
As you can see, getting this type of recycling wrong is to be avoided at all costs.