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Clare Moffat: Why use drawdown recycling and why now?

The problem: Jeff is aged 55. He would like to retire at 65 but he wants to access his tax-free cash now to pay for holidays. As he is still working, he does not need any pension income until he retires at age 65. Jeff has a personal pension with a fund value of £200,000. He understands that Government proposals mean that he may be able to access the full fund from next year but he knows that this may have tax implications as he is a higher-rate taxpayer. He is worried about moving into income drawdown now as he is concerned about the tax charge if he dies. What options are available to him?

The solution: As he does not require any income, then drawdown recycling could be the solution.

How drawdown recycling works

Moving his pension fund into income drawdown and using drawdown recycling means that Jeff can access his tax-free cash and continue to invest in a personal pension by reinvesting the income from the drawdown fund.

This investment, from drawdown income into a pension, is done on a gross-to-gross basis, that is, the gross pension contribution is made equal to the gross income amount.

It is also tax-neutral, so long as there are sufficient relevant earnings to support the contributions into the new pension, as the marginal rate tax on the income from drawdown is offset by the marginal rate relief on the pension contribution. For Jeff, it may not be bank balance neutral. In the short term as he will receive basic-rate relief from the pension provider but have to claim any higher-rate relief through self- assessment but it should work itself out in the longer term.

Why use drawdown recycling?

A personal pension is unvested funds and income drawdown is vested funds. It is generally accepted that unvested benefits are better than vested benefits due to the availability of tax-free cash and the tax-efficiency of benefits on lump sums payable on death.

Drawdown table.8May14

By drawing income from the drawdown fund and increasing the new personal pension fund, Jeff can:

  • Access a “second” amount of tax-free cash which can be taken from the personal pension fund and
  • If he dies, the death benefits increase due to the preferential tax treatment of personal pension death benefits compared with drawdown death benefits.

Drawdown recycling means that Jeff can access his tax-free cash and enjoy spending that now. It also means that he can plan in a tax-efficient manner by investing some of the drawdown income into a personal pension. As Jeff approaches retirement, he will need advice as to what will be appropriate for his circumstances at that point.

Jeff’s options

 
Option 1 Option 2

·       Move full fund from personal pension into drawdown

·       Take 25 per cent tax-free cash

·       Leave the rest of the fund invested in drawdown with no income taken

·       Move full fund from personal pension into drawdown

·       Take 25 per cent tax-free cash

·       Reinvest income each year into a new personal pension

Jeff’s benefits under the two options are as follows:

 
 Jeff’s benefits payable at 65 (cumulative)    
   Option 1 Option 2
 Tax free cash £50,000  £74,218
 Fund for income  £244,334  £220,117
Assumptions: 25 per cent tax-free cash taken, £7,500 income a year. Income and contributions are constant, sustained and paid monthly in advance. Fund growth of 5% a year net of charges.
 Benefits for Jeff’s familty if he dies at 65    
   Option 1 Option 2
 Lump sum benefits £109,950 £163,229
 Tax to pay  £134,384  £81,105

Clare Moffat is technical manager at Prudential 

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Comments

There are 5 comments at the moment, we would love to hear your opinion too.

  1. Julian Stevens 8th May 2014 at 9:23 am

    Income recycling to accumulate a new fund from which eventually another 25% should be available as TFC isn’t a new idea (and nor is it a bad one) but HMRC may enact new measures to block what’s effectively a strategy to get two bites of the TFC cherry. Also, it’ll take a few years to transfer the full value of the vested policy into a new one.

    More and more people are cottoning on to the availability of TFC pre-SRA without full vesting but (if you’re a member of a network) getting it past the compliance people is a nightmare, particularly if early vesting of an old contract will incur penalties. In my experience (which may or may not be typical), far too many clients focus solely on the availability of the TFLS and shut their eyes to the penalties.

  2. Andrew Roberts 14th May 2014 at 9:48 am

    I personally would be worried that this is straying towards pension commencement lump sum recycling – it isn’t just actual payment of the lump sum back to the pension that counts as recycling it also includes pre-planning to increase contributions as a result of having accessed the lump sum.

  3. David Stoddart 14th May 2014 at 1:48 pm

    It also concerns me that that this could be deemed as recycling as I am yet to see rules in black and white to confirm that this is a legitimate process that cannot be challenged by HMRC

  4. Nicholas White 20th May 2014 at 2:04 pm

    It is lump sum recycling and could in principle be caught by the anti-abuse rule, but with care the individual could keep PCLS each year below 1% of LTA, or keep additional contributions below 30% of PCLS: see conditions 5 and 6 here: http://www.hmrc.gov.uk/manuals/rpsmmanual/rpsm09208020.htm

    I suspect that lump sum recycling, within the limits, is going to become more of an issue post 6/4/15, when “flexible drawdown for all” comes in, allowing all individuals to crystallise only the amounts they intend to recycle and preserving better tax-on-death treatment for all funds. I wouldn’t be surprised if reform of anti-recycling rules is already on HMT’s to-do list for the coming year.

  5. Samuel Lewis Mayes 20th May 2014 at 4:09 pm

    I agree with what Nick White and Adrew Roberts said… it’s the pre-planned intent to increase pension contributions that is a by-product of the PCLS that falls foul of DOTAS and GAAR in this instance.

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