‘Is it illegal to recycle pension money to get extra tax relief?’
I’ve heard that it’s possible to fall foul of HMRC’s pension recycling rules; can you explain the pitfalls and how to avoid them please?
HMRC has rules in place to stop pension savers getting ‘double bubble’ on their pension tax relief. As you say, this concept is referred to by the taxman as pensions recycling.
The concept is straightforward and probably easiest to explain with an example. Take someone who is 65 years old and has a SIPP pot worth £100,000. He takes out his maximum tax-free cash (£25,000) but then invests it straight back into another pension with a different provider.
As a result, he gets tax relief on the money he pays into that pension (immediately boosting it to £31,250) and can get 25% of that money (i.e. £7,812.50) tax-free as well. He might even invest that tax relief in another SIPP, and so on.
I’ve heard this wheeze described variously as a ‘no brainer’ and ‘too good to be true’ by investors. Sadly, the latter point is correct and HMRC has rules in place to prevent excessive recycling of tax-free cash. If you breach these rules you could be hit with a 55% unauthorised payment charge.
HMRC will consider recycling of tax-free cash to potentially breach its rules where the tax-free sum (or sums) received over a 12-month period are worth more than £7,500.
The rules kick in where the payment has resulted in a 30% or more increase in contributions to your pension compared to what might normally have been expected.
While this might sound a bit vague, it’s actually a specific condition – HMRC looks at contributions paid in the rest of the tax year after you took your tax-free cash plus up to two more years afterwards. This is then compared with the contributions made during a similar period before tax-free cash was taken.
You can’t get round this by paying into different pension schemes as HMRC will look at all of your contributions when making its assessment.
Equally, HMRC will penalise you for recycling if you borrow money to pay contributions or pay into your pension out of savings and then use the tax-free lump sum to pay off the loan or top up savings.
Incidentally, concerns over recycling were cited by the Government as the primary reason for introducing the Money Purchase Annual Allowance (currently set at £4,000) for savers who access taxable income from their pensions.