How to avoid recycling tax-free cash

  • Describe some of the challenges surrounding recycling of pensions tax-free cash
  • Explain HMRC's stance on the issue
  • Identify ways of managing the process
How to avoid recycling tax-free cash
Joslyn Pickens

Pensions legislation generally works by authorising specific types of payment. 

These ‘authorised payments’ include, among other things, pension commencement lump sums (that is, tax-free cash), pension income, transfers and death benefits, and they are mostly contained in a small number of sections (164 to 171) of the Finance Act 2004.

If a pension scheme were to make a type of payment not listed in legislation, it would not be an authorised payment. The payment would therefore be by definition an unauthorised payment.

Unauthorised payments incur significant tax charges for the member and the scheme, and they are generally to be avoided at all costs. In fact, it is likely that many scheme rules will not permit them.

However, the legislation also lists types of payments that are specifically unauthorised.

There are around a dozen of these and while some are quite rare, one that crops up frequently in questions from scheme members and advisers is lump sum recycling.

What is lump sum recycling?

In broad terms, lump sum recycling occurs when a client takes their tax-free PCLS and then pays it back into a pension as a new contribution.

The logic is that the new contribution would attract tax relief. Therefore, the client would be gaining tax relief on funds that they had received tax-free and which had already benefitted from tax relief in the past – some refer to this as double dipping.

The recycling rule therefore aims to prevent the exploitation of the tax rules.

To be clear, the recycling rules do not extend to pension income. Income must be taxed under PAYE, so there is much less benefit in paying taxed pension income back in as a contribution. The money purchase annual allowance also serves to reduce the viability of recycling income.

What are the conditions for recycling?

Under legislation, several conditions must be satisfied for a PCLS to be considered recycled.

  • The pension scheme member receives a PCLS.
  • The PCLS (and any other PCLS(s) in a 12-month period) come to more than £7,500.
  • The amount of the contribution(s) is more than 30 per cent of the amount of the PCLS.
  • Contributions for the member are significantly above what they would normally be.
  • The contributions can be paid to any scheme belonging to the member, and they can be paid by the member, a third party or an employer.
  • The recycling was planned (a conscious decision).

If all these conditions apply, the value of the unauthorised payment is the value of the PCLS received by the client. 

There would then be a unauthorised payment tax charge of 40 per cent, which the client would be liable for personally. If the client crystallised their entire pension when taking the PCLS, an unauthorised payment surcharge of 15 per cent would also apply (given that the PCLS would account for 25 per cent of the whole pension scheme).

There would also be a scheme sanction charge on the pension itself of between 15 per cent and 40 per cent depending on how much of the unauthorised payment charge the client paid. However, if the scheme administrator was unaware of the client’s plans it may be able to ask HM Revenue & Customs to discharge its liability.

How does HMRC approach recycling?

While most of the above conditions are straightforward to apply, two questions come to mind: