The A-Day changes in 2006 allow contributions with tax relief up to the full level of an individual’s earnings or £3,600 a year gross, if less, meaning that even those on relatively low earnings can contribute substantial amounts. It is also possible to take a pension commencement lump sum but defer income to a later date.
This introduced the possibility that some or all of this lump sum could be reinvested with tax relief. A 25 per cent lump sum would then be available on the reinvested amount and could potentially be reinvested with further tax relief and so on. Potentially significant tax benefits were available from this recycling, so the Government acted to close off the option in the Finance Act 2006. The threat of sanctions seems to have been effective in stopping this type of recycling.
If HM Revenue & Customs suspects that recycling is taking place, it has a number of steps it will follow before imposing sanctions. The trigger for HMRC investigating a contribution is an increase of at least 30 per cent over the contributions that might be expected. If that happens within two years of the tax year when a lump sum is paid, HMRC will look at the amount of the lump sum.
If it is less than 1 per cent of the lifetime allowance when added to any other lump sums paid in the last 12 months, there is no issue. For example, in 2007/08, lump sums up to £16,000 are ignored. The recycling rule kicks in if the cumulative amount of increase, in the tax year of the lump sum and the two before and after it, is over 30 per cent of the lump sum. After this process, there is one more condition. This is that the recycling must have been pre-planned. If the individual only considers recycling the lump sum after it is paid, there is no issue.
The onus is on HMRC to find evidence of pre-planning, not on the individual to prove there was none. It is unlikely that HMRC will go through this process unless the amounts are substantial or there is evidence of systematic recycling by a provider or adviser but care is needed to ensure there is no cause for suspicion.
One relevant area is where an individual makes big pension contributions close to retirement. This is perfectly legitimate if, say, they have saved outside pensions for most of their working life but move into pensions close to retirement. It defers the tax relief rather than increasing it. It also makes sense for those with big pension funds to pay significant amounts close to retirement to take them up to the lifetime allowance, leaving room for investment growth.
Advisers should be careful to explain to clients, and to include in documentation, that the purpose of investing in this way is to increase income, with no suggestion that the contribution will be funded, wholly or in part, by the lump sum that will be payable.
A second possible area of concern is clients who continue to contribute to a pension after starting to take benefits. Again, this is a legitimate use of earnings to increase overall provision while using pension income to maintain their lifestyle. It could happen if a client has retired from full-time employment and receives pension from a defined-benefit scheme but still has earnings which are paid into a personal pension. It could also be used for someone receiving drawdown and making personal pension contributions from earned income. If there is no recycling of lump sums, there is nothing to concern HMRC.
The penalty for recycling is that some or all of the pension commencement lump sum is treated as an unauthorised payment, leading to a 40 per cent tax charge and possibly a 15 per cent surcharge and/or a scheme sanction charge.
It should be avoided at all costs but this does not prevent contributions by older clients to boost pension income. The tax-free lump sum then fulfils its purpose as an incentive but not the source of contributions.
Ian Naismith is head of pensions market development at Scottish Widows