Recycling 

Pension recycling is where an individual reinvests either their tax-free cash or pension income back into a pension scheme. The reinvestment can generate additional tax relief for the client and build up a fresh entitlement to tax-free cash and pension benefits. As the client will have already received the tax relief when contributions were originally made to their pension arrangement, HMRC have legislated to limit the amount of additional tax relief an individual can claim when tax-free cash and certain pension income, such as flexi-access drawdown, is recycled into pension.

Tax-free cash recycling

The recycling rules aren’t intended to stop clients maximising their pension savings in the lead up to retirement - this is considered to be legitimate retirement planning. HMRC accepts that clients will want to boost their pension savings and maximise their pension benefits by funding additional contributions from their salary, savings, investments and even redundancy payments.    

However, HMRC does object to individuals using their tax-free cash to substantially increase in their pension funding. The following rules explain when contributions are likely to be caught by the recycling rules and the tax penalties that can apply.  

Pre-planning

A key point to note is that individuals will only be caught by the recycling rules if the recycling was pre-planned – this is where the individual made a conscious decision to take the tax-free cash with the intention of making a ‘significantly greater contribution to a registered pension scheme’.

Even if the contribution was made before the tax-free cash was actually taken, pre-planning could still be an issue. HMRC can look at contributions made in the tax year that the tax-free cash is taken and two tax years either side - i.e. five tax years in total.

When looking for evidence of pre-planning, HMRC will consider the motivation for taking the tax-free cash and decide whether the client always intended to make a contribution due to the payment of tax-free cash.

Recycling rules

Assuming the recycling was pre-planned, an unauthorised payment charge will apply to the tax-free cash taken if all of the following limits are exceeded.

• The tax-free cash (including any tax-free cash taken in the past 12 months) is more than £7,500 and
  
• The cumulative total of the increases in pension payments in the tax year, and the two tax years either side (a total of five tax years) is at least 30% of the tax-free cash taken, and 
• The pension payments made are significantly larger (generally 30%) than might be expected.

If recycling is kept within these limits, tax-free cash can be used to make payments into a pension scheme (even with pre-planning).

It's also worth noting that tax-free cash can be used to fund someone else's pension without falling foul of the tax-free cash recycling rules - for example, making payments to a pension for a spouse/partner, child or grandchild. The rules only apply when the individual is recycling tax-free cash back into a pension in their own name.

Tax penalties

Tax-free cash caught by the recycling rules will normally be treated as an unauthorised payment. The amount of the unauthorised payment is the tax-free cash taken, not the amount that’s recycled back into pension.

Unauthorised payments can be subject to several tax charges:

• an unauthorised payments charge of 40% (scheme member);
• an unauthorised payments surcharge of 15% (scheme member);
• a scheme sanction charge, normally 15% (the scheme).

Where the unauthorised amount (i.e. the tax-free cash taken) is 25% or less of the fund value, the 40% tax charge will apply. For clients entitled to more than 25% tax-free cash (i.e. those with protected tax-free cash) the 15% unauthorised payment surcharge will also apply. The 15% scheme sanction charge applies where the scheme administrator knowingly makes an unauthorised payment. 

Informing HMRC

If an individual pre-plans tax-free cash recycling and it's caught by the recycling rules, they must notify the scheme administrator within 30 days of the date that the unauthorised payment is deemed to occur.

Failure to do this within the required 30 day period can result in a penalty of up to £300, with the possibility of further penalties of up to £60 a day for as long as the notification remains outstanding. Providing incorrect or incomplete information can result in a penalty of up to £3,000.

In addition, the individual should also inform HMRC of the payment. This can either be done through their self-assessment income tax return or by contacting their local HMRC office if they don’t complete a self-assessment. 

What doesn’t count as tax-free cash recycling?

Even when tax-free cash has been taken, HMRC accept that not all increases in pension contribution should fall foul of the recycling rules.

HMRC Pension Tax Manual – PTM133800 gives several examples of increases that are not deemed to be recycling. These include situations where an individual:

• joins a new employer’s schemes and pays the required contribution for the new employers pension scheme
• receives a windfall, such as an inheritance or lottery win and makes a pension contribution as a result
• keeps their contribution rate the same, e.g. 10% of profits, but due to an increase in profits there is a significant increase in the contributions

Pension income recycling 

Individuals can recycle excess pension income into their pension scheme, within the normal tax relief and annual allowance rules. But there’s an additional restriction for those who have taken benefits flexibly from a defined contribution scheme as this normally triggers the money purchase annual allowance (MPPA). But if someone has inherited pension funds, these can be taken flexibly without triggering the MPAA.

If the MPAA has been triggered, for example where someone has taken income from a flexi-access drawdown arrangement or taken an uncrystallised funds pension lump sum (UFPLS), their allowance for contributions to defined contribution schemes will be limited to £10,000 per tax year. Contributions in excess of this amount would be subject to an annual allowance tax charge.

It’s important to note that pension income is not classed as relevant UK earnings, (i.e. it’s not income from employment/self-employment) and is non-pensionable. A client would need to have sufficient relevant UK earnings to justify contributions above £3,600 in a tax year.

Please see our Technical Guide on Annual Allowance for full details on the MPPA.