To reduce the tax incentive for people to recycle income in this way, there are rules in place to make this less attractive. These consist of:
- The Money Purchase Annual Allowance (MPAA) – triggered when an individual flexibly accesses their pension benefits. This restricts the amount that can be paid into a money purchase pension arrangement to £10,000 before a tax charge becomes due.
- The Pension Commencement Lump Sum (PCLS) Recycling rules – triggered when someone intentionally uses their tax-free cash to increase contributions significantly to a registered pension scheme. This causes the PCLS to be treated as an unauthorised member payment.
PCLS recycling rules in detail
The recycling rules apply in respect of any PLCS (tax-free cash) taken where the lump sum is used as part of a recycling device. This is regardless of when any significantly increased contributions are actually paid. The recycling rule applies when all the following conditions are met:
- The individual receives tax-free cash.
- Because of the tax-free cash, the total of all pension contributions made are significantly greater than otherwise would be expected – broadly, have increased by 30% or more.
- The recycling was pre-planned.
- The cumulative amount of the additional contributions exceeds 30% of the tax-free cash received.
- The total amount of tax-free cash taken over a 12-month period, exceeds £7,500.
Areas to be aware of (often not well understood)
The rules around tax free cash recycling are not always well understood. It is important to remember the following:
- It does not matter who made the contributions for tax free cash recycling to have taken place – it could be the member, their employer or someone else.
- HMRC don’t just consider pension contributions made in the tax year the tax-free cash is taken to see if they have significantly increased. They will also look at all contributions made in the two tax years before tax free cash is taken and two tax years following.
- The recycling rule can still apply where the contribution isn’t funded directly from the tax-free cash. It still applies where a contribution is made using available savings or a short-term loan, which is repaid using the tax-free cash.
- Pre-planning occurs when the individual made a conscious decision (and will therefore be aware of the intention) to use tax free cash as the direct or indirect means to pay significantly greater pension contributions.
- Where there is a dispute, the onus is on HMRC to show pre-planning took place before the tax-free cash was paid.
Example
Laura, 53, earns £42,570 pa and holds a private pension valued at £240,000, plus a cash ISA worth £60,000.
Her financial position over the next two years is as follows:
| Year 1 | Year 1 | Year 2 | Year 2 | |
| Chargeable | Payable | Chargeable | Payable |
|
| Income Tax | £42,570 | £42,570 | ||
| Personal Allowance | £12,750 | £0 | £12,570 |
£0 |
| Basic rate tax @ 20% | £30,000 |
£6,000 |
£30,000 | £6,000 |
| National Insurance | £42,570 | £42,570 |
||
| Employee NIC (8% between £12,750 - £50,270) | £30,000 | £2,400 | £30,000 |
£2,400 |
| Employer NIC (13.8% between £9,100 - £50,270) |
£33,470 | £4,619 | £33,470 | £4,619 |
| Net Pay | £34,170 | £34,170 |
||
| Gross Pension Contributions | £0 | £0 | ||
| Savings | £300,000 | £300,000 | ||
| Pension | £240,000 | £240,000 |
||
| ISA | £60,000 | £60,000 |
After discussing with her financial adviser, Laura asks her employer to increase pension contributions by £30,000 via salary sacrifice. This means her income reduces to £12,570 and falls within the tax-free personal allowance.
Laura will then use her ISA savings of £60,000 to supplement income until she reaches age 55, when she intends to take sufficient tax-free cash to replenish these savings:
| Year 1 | Year 1 | Year 2 | Year 2 | |
| Chargeable | Payable | Chargeable | Payable |
|
| Income Tax | £12,570 | £12,570 | ||
| Personal Allowance | £12,570 | £0 | £12,570 |
£0 |
| Basic rate tax @ 20% | £0 | £0 | £0 | £0 |
| National Insurance | £12,570 | £12,570 |
||
| Employee NIC (8% between £12,750 - £50,270) | £0 | £0 | £0 |
£0 |
| Employer NIC (13.8% between £9,100 - £50,270) |
£3,470 | £479 | £3,470 | £479 |
| Net Pay | £12,570 | £12,570 |
||
| Gross Pension Contributions | £30,000 | £30,000 | ||
| Savings | £300,000 | £300,000 | ||
| Pension | £270,000 | £300,000 |
||
| ISA | £30,000 | £30,000 | £0 |
£30,000 |
This effectively means Laura can receive her annual income tax free for the next two years, increasing her take home pay from £34,170 to £42,570 per year. This will save her £16,800 ((£42,570 - £34,170) x 2) in income tax and National Insurance, without materially affecting the amount held in her savings.
In addition, Laura’s employer will also benefit from a material reduction in the employer NI contributions they pay (from £4,619 per year to £479 per year).
Potential pitfall with this approach
Unfortunately, if Laura does take the tax-free cash to replenish her ISA savings, this strategy is likely to have met all the conditions to be treated as tax free cash recycling:
- Laura has received tax-free cash.
- The total amount of the additional contributions (£60,000) exceeds 30% of the tax-free cash received (£60,000).
- The tax-free cash received (£60,000) exceeds £7,500.
- Because of the tax-free cash, contributions into Laura’s pension scheme are significantly greater (an increase of over 30%) than they otherwise would be.
- The strategy was pre-planned.
The last two points are hardest to prove, and it must be remembered that the onus is always on HMRC to show that tax free cash recycling took place (i.e. it was pre-planned). However, if the intention was always to replenish the savings using the tax-free cash, the tax-free cash would appear to indirectly have funded the contributions and the decision to do this was pre-planned.
In this example, Laura was acting on advice from a financial adviser – it is therefore likely that the suitability report or written recommendation would contain sufficient evidence for HMRC to determine what Laura’s intentions were. i.e. that this strategy was pre-planned.
Comment
Most people reaching age 55 won’t yet be ready to retire but may still decide to access some or all of their tax-free cash entitlement. At the same time, these people are at an age where it is often advisable to look to maximise pension contributions to ensure they have sufficient retirement funds for when they do retire.
In the vast majority of cases, any contributions made, and tax-free cash taken will be carried out as part of normal retirement planning. However, it is important to be aware of the recycling rules and consider whether any recommendations made could be viewed as evidence of pre-planned tax-free cash recycling.
Detailed guidance around tax-free cash recycling, including examples of when the rule applies and when it doesn’t can be found within the Pensions Tax Manual.
Important information
Please note this is for general information only and is based on LV's understanding of the relevant legislation and regulations and may be subject to change.
The tax treatment of benefits depends on individual circumstances, and may be subject to change in the future.
The use of this document is at your own risk, and the content should not be used for the provision of professional advice.
LV= accept no liability for any damages, losses or causes of action of any nature arising from your use of this document.