Maximising tax efficiency when you take money from your pension savings is a tricky business. What are the key issues you should consider?
Pension relief escapes change
There are tough anti-avoidance rules which penalise unfair tax avoidance using pension contributions and the government wants to encourage pension saving. This means there’s still a limited opportunity to use pension “recycling” to obtain a tax saving.
Reduced opportunity to recycle
Since April 2017 the advantage of pension lump sum recycling has been significantly reduced, plus these days there’s the added complication of pensions auto-enrolment to factor in. To comprehend these limitations you need to understand how pension recycling works.
What is recycling?
Recycling involves taking some or all of the tax-free element of your pension savings and reinvesting it into a new pension plan. The new contribution qualifies for tax relief and generates an entitlement to a new tax-free lump sum. In effect, you’re using your original tax-free payment to create more tax-free income at no extra cost.
Limitations – the MPAA
Pension recycling is a good tax wheeze, however you need to be wary of the limitations and penalties that can apply if you overstep the mark. The first of these is the money purchase annual allowance (MPAA). This caps tax relief on pension contributions in most situations where you’ve drawn money from your pension savings under an arrangement made after 5 April 2015. The cap means that tax relief you receive for pension contributions in excess of £4,000 per year is clawed back through the annual allowance charge. Also, if HMRC considers that you’ve exceeded the limits for recycling pension contributions, there are very stiff financial penalties.
Trap. Auto-enrolment pension contributions (yours and your employer’s) count toward the £4,000 MPAA.
Tip. When the MPAA applies there’s a claw back of tax relief for contributions in excess of £4,000 per annum. But there’s no financial penalty unless you’ve received more than £7,500 pension tax-free cash in the previous twelve months, or if you have, you haven’t increased your pension contributions by more than 30%.
Is it worth the risk?
Provided that you avoid paying contributions at a rate that triggers a penalty, reinvesting at the £4,000 per year maximum allowed by the MPAA can build an extra tax-free lump sum. Assuming an annual growth rate for your fund of, say, 5% per year, annual recycling could generate an extra £13,000 tax-free cash over ten years. The bottom line is that just because you have or are taking money from your pension savings this doesn’t prevent you from continuing to build another tax-free lump sum.
This article has been reproduced by kind permission of Indicator – FL Memo Ltd. For details of their tax-saving products please visit www.indicator-flm.co.uk or call 01233 653500.