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My wife has been advised by our independent financial consultant that she can draw down extra money each month from her private pension – while remaining under the annual income tax threshold – and re-invest the surplus. The Government will then contribute an extra 20pc on these monthly re-investments, as it did when I paid into the pension each month for 10 years before I retired. This was intended to give her a bit of extra support if I die before her.
The adviser also says she can then take out 25pc of that re-invested surplus at the end of each year as a tax-free lump sum. Whilst I doubt he would advise us to consider something illegal, it seems strange that this is allowed. The downside as I see it is my wife’s private pension would deplete slightly quicker. She receives her state pension in three years’ time after which I guess this re-cycling could be pointless due to incomes being well over the tax threshold. What should I do?
David Waterman, via email
You are right to be concerned about this. There are extremely complicated rules around pension tax recycling and it is easy to fall foul of them. Recycling is where an individual reinvests some, or all, of either their tax-free cash or pension income back into a pension scheme. This can generate additional tax relief and build up a new entitlement to tax-free cash and pension benefits.
HM Revenue & Customs rules limit the amount of tax-free cash that can be recycled. This became a much bigger issue once the so-called pension freedoms were introduced in 2015.
Without the tax-free cash recycling rules, from age 55, in theory people could continually take out tax-free cash, having already benefited from tax relief on contributions previously made, then reinvest some or all of their lump sum specifically to benefit from more tax relief on the new contributions made. The tax-free cash recycling rules are designed to stop people manipulating the tax rules in this way.
If your wife triggers these rules, she could face a tax charge from HMRC as the relevant tax-free cash payment made would be treated as an unauthorised payment.
Pension contributions and earnings
Assuming your wife isn’t currently working, she is able to pay into her pension, up to £2,880 net per tax year. If this is a personal pension, the provider will claim 20pc tax relief from HMRC to top up this amount to the maximum of £3,600 gross per tax year.
If income is taken flexibly from a pension, it triggers the money purchase annual allowance. This means the amount saved in a money purchase pension without a tax charge would fall from a maximum of £40,000 each tax year to only £4,000. However, assuming your wife can only pay pension contributions up to £3,600 a year anyway, with tax relief, she won’t be affected by this.
Recycling tax-free cash
The tax-free cash recycling rules are complicated, and all of the following conditions need to be met for tax-free cash recycling to have taken place.
- The recycling is “pre-planned”
- The tax-free cash taken, either alone or in total with other tax-free cash amounts taken in the previous 12 months, is more than £7,500
- There is a “significant increase” in the level of expected pension contributions (personal, employer and/or third-party contributions) to any one or more registered pension schemes because of the tax-free cash taken, or to be taken
To meet the third condition, both of the following must apply:
- There is an increase in contributions of more than 30pc of the contributions that might otherwise have been expected, based on a number of factors, such as contribution history and current contractual rate of contributions, and
- the increase in contributions is more than 30pc of the tax-free cash lump sum that the member took (or is due to take)
Pre-planning is where a conscious decision is made to take tax-free cash purely so someone can significantly increase their pension contributions, whether paid by themselves as personal contributions, whether someone does it on their behalf (third party contributions) or by an employer.
If your wife’s intention is to take small amounts of tax-free cash every year, then effectively using this to make pension contributions she will meet the “pre-planning” condition.
Measuring significant contributions
The “significant increase” rule is assessed on a cumulative basis. This is to prevent people avoiding the rules by increasing contributions on a piecemeal basis or gradually over time. HMRC will look at contributions and tax-free cash taken over a five-year testing period.
Assuming the tax-free cash is taken in this tax year, HMRC will look at the contributions made in the current tax year and the two tax years before and after. This gives a five-year testing period.