Rumours about the government tinkering with tax-free cash (TFC) are rife.
Whispers are that Labour is looking to slash the amount you can take as tax-free. And this is driving investors to take the cash now in a bid to protect it from any potential TFC axe.
However, if you’re considering taking your TFC, it’s important you don’t make any hasty decisions you might regret later down the line.
Taking TFC could leave you open to an array of taxes like inheritance, capital gains and dividend tax, which all work to take a chunk out of your hard-earned savings.
To get around this, some people might think of just putting their TFC back into a Self-Invested Personal Pension (SIPP). However, this comes with its own risks and could land you with a very hefty tax charge.
This article isn’t advice. The government’s Pension Wise service can help if you’re over 50 and need guidance. You can also get personalised financial advice if you need it. Pension and tax rules can change, and any benefits depend on your circumstances. Remember, you can't usually access money in a pension until you're 55 (rising to 57 in 2028).
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Pension recycling – what is it and what are the rules?
Pension recycling is when someone reinvests some, or all, of their tax-free cash, back into their pension to maximise tax-relief.
The idea being that by putting the money back into your pension, you can generate additional tax relief, and possibly build up fresh entitlement to more tax-free cash.
However, there are limits to HMRC’s generosity.
This is money that you typically won’t have paid any tax on, because you would’ve received tax relief when contributions were originally made and paid no tax on the withdrawal – this is where they draw the line, and it could be one you unwittingly cross.
Limited recycling of tax-free cash is possible. However, if you’re caught on the wrong side of the recycling rules, you could end up facing a significant penalty that would likely outweigh any benefit.
The tax-free cash will be treated as an unauthorised payment, and you could pay a charge of up to 55% of its value.
What are the TFC recycling rules?
Here’s a run-down of the recycling rules (all criteria must be met to be deemed a breach of the rules):
Tax-free cash is taken.
Tax-free cash taken exceeds £7,500 (including any other tax-free cash taken in past 12 months).
Contributions into pensions are significantly higher than what’s expected. This applies to personal, employer and third-party contributions.
The value of the contribution increase is more than 30% of the tax-free cash taken. (The recycling rules take into account contributions paid in the tax year in which the tax-free cash is taken, as well as the two tax years either side of this).
Recycling was planned by the member – the onus is on HMRC to evidence it was a conscious decision.
To help, here are a couple of scenarios:
Fran takes £150,000 tax-free cash on 1 October 2024 and increases her annual contributions to her workplace pension by £10,000. This takes her annual contributions from £15,000 to £25,000.
Her contributions remain at that level for the next two tax years.
Because the cumulative increase in the value of the total contribution is less than 30% of the tax-free cash taken, she hasn’t broken the recycling rules.
You receive £60,000 tax-free cash. You plan to use part of the tax-free cash to pay off your mortgage and part to top up your pension. Over the previous few years, you have been contributing £3,000 a year to your pension.
After paying off your mortgage you reinvest £30,000 in a pension plan. However, as this investment was preplanned, it’s a significant increase and represents more than 30% of the tax-free cash, it is caught by the recycling rules.
Consequently, you could have to pay up to £42,000 tax on the tax-free cash of £60,000. The overall tax charge here is 70%, not 55%. This includes a scheme sanction charge that can be levied on the provider.
For anyone who’s already withdrawn their tax-free cash out of fear of possible changes, it’s worth noting that the recycling rules only apply to your own pension. They don’t apply when your TFC is used to boost someone else’s pension, like a spouse’s or a child’s pension.
Remember, these are just examples to help explain the rules – they’re for illustration purposes only.
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Our advisers can recommend how you can make the most of your tax allowances through financial planning. But if you need complex tax calculations, your adviser might recommend you speak to an accountant to complement their advice.