We recently explained to readers (IC 18 April 2014) how income taken via flexible drawdown can be used to boost a spouse's pension. However, a reader has since contacted us to ask for more information about HMRC’s "recycling rule" on pensions, which applies to the 25 per cent tax-free pension lump sum. This means that if you want to put the tax-free cash back into another pension scheme, in certain circumstances there could be a tax penalty.
HMRC introduced recycling rules in 2006 as it was concerned that recycling could abuse the generous tax relief system. Anyone who falls foul of these rules could face tax penalties of up to 55 per cent.
Andrew Tully, pensions technical director at MGM Advantage, explains: "Recycling applies where tax-free lump sums taken from a pension are deliberately and with pre-planning used to increase pension contributions for the same individual. There are various complex limits around how much lump sum needs to be taken and how much increase in contributions can be made without triggering these rules."
The onus is on HMRC to prove a pre-planned intention to recycle. They have to prove beyond doubt that an individual pre-planned their affairs so as to use their tax-free cash to make significantly higher pension contributions, thereby qualifying for further benefits and tax relief.
It should be noted that very few lump-sum payments will be affected by this recycling rule because the rules aren't intended to catch individuals with small funds. If the tax-free lump sum is less than 1 per cent of the pension lifetime allowance and no other tax-free cash has been received in the previous 12 months, it would not be caught under the recycling rules, even if this was pre-planned. That means an investor can recycle a tax-free lump sum of up to £12,500 back into a pension without penalty.
In the case featured in IC 18 April 2014, the individual was taking flexible drawdown so was taking a tax-free element and also a taxed element. "If any increase in contributions can from the taxed element then that is acceptable," says Mr Tully. "But in any case, the increase was paid into the wife's pension plan so it doesn't fall within one of the basic recycling tests - increased contributions for the same individual."
A link to the HMRC summary guidance on the recycling rule can be found at: http://www.hmrc.gov.uk/manuals/rpsmmanual/RPSM04104920.htm
