In broad terms, recycling means taking money out of a pension scheme and paying it back in as a contribution.
Some or all of the withdrawals might be tax-free on the way out. The contributions should attract tax relief on the way back in. So the overall aim is to use them in tandem to increase pension funds.
We’re often asked about recycling in the context of the tax-free pension commencement lump sum (PCLS). However, it’s worth thinking about it in other contexts as well.
First let’s look at the definition.
- The pension scheme member receives (over twelve months) one or more PCLSs that exceed £7,500 in total.
- Because of these lump sum(s), pension contributions increase significantly from what they would otherwise be.
- The additional contributions are made by the member or by a connected party, and can be made to any scheme belonging to the member.
- The cumulative amount of additional contributions exceeds 30% of the PCLS.
- The recycling was pre-planned.
If all of the above conditions apply, the PCLS would be considered an unauthorised payment, which means it would incur significant tax charges. So what does this mean in practice?
Given the definition focuses on PCLS, it’s possible to recycle income from a drawdown fund.
However, if it’s paid from flexi-access drawdown (rather than capped drawdown), the income will trigger the money purchase annual allowance (MPAA), which reduces the amount you can pay back in to a maximum of £4,000 a year.
Pension income from a defined benefit pension or a lifetime annuity is not subject to the MPAA, but there is less flexibility compared with drawdown over how much you can take out. This might make it harder to plan effectively.
Other lump sums do not fall foul of the recycling rules. Paying back in a serious ill-health lump sum, for example, is not recycling, but the contributions could be considered a ‘transfer of value’ for inheritance tax purposes.
Paying in small pot lump sums or uncrystallised funds pension lump sums (UFPLS) is also not viewed as recycling (although taking an UFPLS does trigger the MPAA).
It’s clearly, therefore, scenarios involving PCLSs that need most consideration.
The challenge for advisers is that, while there is official guidance from HM Revenue & Customs (HMRC), there are no known tax tribunal or court cases to demonstrate how HMRC approaches it in practice.
The purpose of the rule is seemingly to act as a deterrent, and consequently I’m not aware that it’s actively checked or pursued by HMRC.
It’s worth noting as well that the onus is on HMRC to prove it (not on the member to disprove it), and there is no requirement on pension scheme administrators to monitor for it or report it.
That said, it would still be wise to ensure that any retirement planning does not involve a direct causal link between a PCLS and contribution increases for the client.
So if a client is taking a PCLS, but they don’t need all of it – perhaps if they’re approaching normal retirement date in a defined benefit scheme – what could they do?
One option is to make pension contributions for family members.
These are not caught by the recycling rule, and it still achieves the same overall effect of boosting pension funds, albeit in the context of the whole family rather than just the client themselves.
Martin Jones is technical team leader at AJ Bell