Pension recycling: what is it and what are the rules?

At a glance, recycling your pension is a straightforward process that involves moving pension money between schemes.

The aim is to gain maximum tax relief that is applied to pension funds. 

It’s usually used to recycle all or some of a tax-free lump sum, which applies to the 25 per cent of your pension pot that you can withdraw from the age of 55 without paying income tax.

We look at the uses, rules and regulations of pension recycling below.

What are the pension recycling rules?

You can use pension recycling to boost your pension contributions and gain extra tax relief.

But HMRC can impose a charge of up to 70 per cent of the value of your tax-free cash to prevent people from trying to exploit the rules and benefit from artificially high tax relief.

The rules will not usually be applied to normal retirement planning. 

So, when could you be affected by the pension recycling rules?

If all of the things below happened, you could incur a tax charge from HRMC: 

• You take a tax-free lump sum from a pension 
• Contributions paid into a pension are larger than they would have been, because you have added some tax-free cash 

• After assessing your case, HMRC have decided that the recycling was pre-planned 
• The amount of tax-free cash you take is more than £7,500, when added to any tax-free cash taken in the previous 12 months 
• The amount of all additional contributions exceeds 30 per cent of the tax-free cash 

HMRC is generally only concerned if they see an increase in excess of 30 per cent on expected contributions. Only then will they consider applying the extra tax charge. 

Here are two examples, which show how you would be exempt, and how you could be liable. 

Example 1: the right side of the rules

You take £5,000 tax-free from a pension and reinvest it in another pension plan.

As long as you had no other tax-free cash in the previous 12 months, you would not be caught by the recycling rule, as the cash did not exceed £7,500. 

Example 2: the wrong side of the rule

You’ve been contributing £5,000 a year into a pension, and you then make a £100,000 contribution and subsequently take out pension benefits that include £100,000 in tax-free cash.

This was clearly pre-planned and exceeds the 30 per cent tax-free cash limit too, so is caught by the recycling rules. 

It pays to tread carefully

There’s nothing inherently wrong with pension recycling.

It can be an effective way of maximising your tax benefits and growing your pension pot.

The problem is that it’s a complex and legally tricky area that won’t suit everyone.

Make a mistake and you could end up paying out far more than the potential tax benefits you were hoping to enjoy. 

If you are thinking about recycling part of your tax-free lump sum, it’s essential to do some research so that you understand the HMRC rules and restrictions.

It would also be a very good idea to talk to a professional tax adviser, who will be able to guide you around the potential pitfalls and assess whether this is a strategy that fits your circumstances.

Pension and tax rules change quite frequently too, so you’ll need up-to-date, personalised advice if you are seriously considering pension recycling.