One key aspect of pension recycling is the option to withdraw 25% of your accrued pension fund tax-free. However, if you reinvest this tax-free amount, which has already received tax relief, to claim additional tax relief, HMRC considers this misuse. To prevent abuse, HMRC treats the entire Pension Commencement Lump Sum (PCLS) as an unauthorised payment when certain conditions apply.
It’s important to note that with Final Salary schemes, you should simply call it your pension commencement lump sum rather than the 25% tax-free amount. Final Salary schemes do not provide the full 25% PCLS. To access the full 25%, you need a personal pension, such as a SIPP.
Watch our CEO and Independent Financial Adviser, Dominic James Murray, explain “What is Pension Recycling?” in the video below
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What Is Pension Recycling?
Pension recycling happens when you reinvest tax-free cash or income from your pension back into a pension scheme to gain additional benefits. Legislation protects this system to prevent people from manipulating the tax breaks on pension contributions.
For example, in this case:
A pension member has a million pounds, and after deducting their 25% PCLS, they have £250,000 in their bank account. Then they realise they should contribute another £250,000 to their SIPP or one of their pension schemes in order to receive additional tax relief on the amount of money. Advisers refer to this practice as pension recycling.
When Does Pension Recycling Actually Happen?
You breach the recycling requirements if HMRC determines that you pre-planned the recycling. Such as if you intentionally took the tax-free funds intending to make a larger contribution to a registered pension scheme.
When looking for evidence of pre-planning, HMRC will evaluate your purpose for taking the tax-free cash. They will then determine whether you always meant to make the contribution with the tax-free cash payment.
Once it is determined that the recycling was planned, HMRC will consider whether:
- The tax-free cash is more than £7,500 including any tax-free cash taken in the previous 12 months;
- The total increases in pension payments in the tax year and the two tax years either side is at least 30% of the tax-free cash taken;
- The pension amounts paid are significantly larger than might be expected. The usual threshold for defining “much higher” is 30%.
Are There Any Exemptions to the UK Pension Recycling Rules?
HMRC accepts that increases in pension contributions do not violate the recycling requirements in the following cases:
- First, when a person wins or gains a stream of revenue, such as an inheritance or a lottery win, and contributes to a pension as a result.
- Second, they maintain the same contribution rate, for example, 10% of profits, but when profits increase, the contributions climb significantly.
- Third, they enrol in a new employer's scheme and make the required contribution to the new employer's pension plan.
Keep in mind that HMRC bases the unauthorised payment charge on the amount of tax-free cash you withdraw. They do not base it on the amount you recycle back into your pension.
What Are the Implications of Pension Recycling?
These rules strictly limit pension recycling. Even with careful planning, you can only use tax-free cash for pension contributions within certain boundaries. If you break all of these rules, HMRC will likely issue an unauthorised payment charge.
The penalties can vary, but the points covered in the following rules are significant. If a person is caught by the recycling rules, the amount of the tax-free lump sum is considered an unauthorised payment. Any of the following penalties may be imposed:
- A 40% unauthorised member payment charge on the tax-free lump sum paid
- A 15% fee on unauthorised payments of the tax-free lump sum paid
- A scheme sanction fee of 40% of the tax-free lump sum
Keep in mind that all of these costs may be charged for a single unauthorised payment, which is not automatic.
What Is the Procedure for Paying an Unauthorised Payment Charge?
When an unauthorised payment happens, the scheme administrator should notify the scheme member and report it to HMRC. You must report all unauthorised payments to the scheme administrator.
Once the scheme administrator has fully informed the pension member of the condition, the pension member must include the breach in their self-assessment. HMRC's HS345 form particularly explains the information required to fill out the unauthorised payment charges. If you are unfamiliar with the matter, you can read the specific information provided by HMRC in section PTM133800, you can contact HMRC to complete your liabilities, or you can call your pension transfer specialist to acquire a thorough explanation.
Our Advice
Clients should avoid PCLS recycling at all costs, according to our recommendations. The matter, however, is exceedingly tough to understand. So, for example, if your contributions to your scheme are significantly more than anticipated, the HMRC provides guidelines of roughly 30%, but this is not a hard and fast rule.
Another piece of advice is to ask yourself a serious question, such as why take your PCLS if you're just going to deposit it in your bank? How would you spend the money? Some people reach the age of 55 with their SIPP, take the benefit of 25% PCLS prematurely, and believe that withdrawing the benefit without further planning is a disaster for financial planning.
As a pension wrapper, the fund you have put into the pension plan is exempt from capital gains tax. As a result, if you retain your money invested in your SIPP, for example, your money will grow as long as you keep the scheme. So, you don't have to run in to cash out your 25% PCLS if you don't have an emergency.
Unless you have a specific plan for the PCLS, leave it in the pension scheme; you don't have to take it at 55; you might take it at 56-65, let the money compound, and then take the PCLS amount that you require when you have a project, or you need it.
You do not have to take the entire 25% of your PCLS. Assume you have a million-pound pension plan and need to build a conservatory, which will cost you thirty thousand pounds. Do you need to take two hundred and fifty thousand pounds now to get that thirty thousand pounds? No, as you will then have £220,000 in your bank account.
Another advantage to keeping your money invested in the scheme is that you will get a tax-free inheritance. If the money increases, when you die you can leave it to your beneficiaries tax-free, as long as you do so before the age of 75.
If you live outside the UK, you have one option: you can withdraw the 25% PCLS and invest it in an ISA, which is also exempt from the capital gains tax, but you can only deposit up to £20,000 into an ISA every year at the time of writing.
What Is the Procedure for Paying an Unauthorised Payment Charge?
Navigating the complexities of pension recycling and understanding the tax implications of your PCLS can be daunting. Many individuals unintentionally fall foul of HMRC’s recycling rules. It happens often when withdrawing their lump sum without a clear financial plan.
The key takeaway: just because you can take the 25% tax-free lump sum doesn’t mean you should. Unless you have specific intentions for the funds, it may be wiser to keep the money invested within your pension. There, it can grow tax-free and potentially be passed to your beneficiaries without inheritance tax (if you pass away before age 75).
If you’re an expat or UK resident considering a SIPP or Final Salary pension transfer, it’s vital to seek advice from a regulated and experienced adviser who understands both UK and international pension rules.
Book your free consultation today. Speak with a qualified Cameron James adviser to protect your pension, avoid costly mistakes, and plan a more secure financial future.