Tony Wickenden: Watch out for the pension contribution bear trap

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Over the past few weeks, I have looked in some detail at remuneration planning for SME owners in the light of the changes to dividend taxation. Well, we should also consider how a pension fund might be incorporated into this planning and, if it can, whether and to what extent the pension fund can be tax-efficiently and NI-efficiently topped up by company contributions if money is drawn from it to replace remuneration. So, with all of that in mind, I would like to consider how the pension commencement lump sum can be used in remuneration strategies.

In doing this for Techlink Professional, the team examined the possibilities for those who have reached minimum pension age and who can, in theory, draw pension benefits to provide “income” and use company profits that would otherwise be remuneration in some other way,  for example, to top up the depleted pension fund.

As an example, a 40 per cent taxpaying director with an existing pension fund could look to:

  • Place £30,000 of pension fund into flexible drawdown;
  • Draw £7,500 as PCLS, thereby giving themselves some tax-free “income”;
  • Arrange for their company to make a pension contribution of £14,716, assuming an available annual allowance and no lifetime allowance constraints. As the table (right) shows, this figure equate to the cost of providing £7,500 of net pay.

The employer pension contribution would effectively replace about half of the PCLS entitlement that was used up in the exercise and increased the total pension fund by a net £7,216.

This sounds relatively simple, but there is a major bear trap to watch out for – recycling. The recycling rules are explained in detail in the HMRC Pensions Tax Manual (PTM)133810, and apply where:

(i)PCLS payments in excess of £7,500 are taken in any 12-month period; and
(ii)  “Because of the lump sum” there has been “a significant increase in contributions”. PTM133830 explains the HMRC criteria for “a significant increase”. Broadly speaking, this is an increase of over 30 per cent on a cumulative basis in total (employer and employee) contributions over a five tax year time period that covers:

a: The tax year in which an individual takes a PCLS “with the intention of using it to make significantly increased contributions to a registered pension scheme”, whether directly or indirectly;

b: The two tax years immediately preceding the tax year in which the individual took the PCLS; and

c: The two tax years immediately following the tax year in which the individual took the PCLS.

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PTM133810 has a section on “Circumstances where the recycling rules do not apply”, which states:

“An individual might pay significantly greater contributions as part of normal retirement planning and might simply fund those contributions from the sale of investments, deductions from salary, salary sacrifice, redundancy sacrifice or from existing savings. A pension commencement lump sum might be an integral aspect of the increased contributions in that one of the reasons for increasing contributions is to receive a larger lump sum.

The recycling rule will not apply in these circumstances unless the individual intended to use that pension commencement lump sum as the means of making those increased contributions, whether in a direct or indirect way.”

One way to sidestep the recycling issue is to stick to the £7,500 per 12-month limit. Another obvious tack is to avoid the 30 per cent and above overall contribution increase. The latter option may not be as much of a constraint as it seems, given that the annual allowance is £40,000, which implies that if regular contributions are over £30,770, an increase above 30 per cent would have to rely upon carry forward to avoid an annual allowance charge.

A more radical approach, which is open to those with a range of pension plans, is to take advantage of the “small pots” rule. I will consider this next week.

Tony Wickenden is joint managing director of Technical Connection. You can find him Tweeting @tecconn