Maureen Duckworth goes through the issues surrounding recycling tax free cash
Nowadays, we're all encouraged to recycle, from tin cans and bottles to old televisions. It's a good thing to do. Good for the environment, good for our future; and you feel good when you do it too - you're doing your bit. However, recycling is likely to cause serious problems if it involves tax-free cash (now known as pension commencement lump sum).
Tax-free cash recycling is where a pension scheme member takes a tax-free lump sum and directly or indirectly reinvests the money in a pension scheme. HM Revenue & Customs (HMRC) don't want tax-free cash used in this way. They are concerned that it could be used to exploit the generous tax relief available to pension contributions. So, how do you know if tax-free cash recycling has taken place?
Recycling takes place where certain conditions, set out by HMRC, are met. All of the five conditions have to be met for recycling to apply.
1. Here's the obvious one. Tax-free cash has to have been taken from a pension scheme. This includes all tax-free cash from any pension scheme over a 12-month period.
2. The total of all tax-free cash payments in a 12-month period has to be over 1% of the standard lifetime allowance. This equates to Â£16,500 in the 2008/09 tax year.
3. The contributions paid by the member, their employer or a third party on their behalf have to increase by more than 30% of what might have been expected. For the purposes of this condition, contributions in five tax years need to be considered. The tax years are the ones in which the tax-free cash is taken, the two tax years before that one and the two after.
It's worth noting that if this condition is met it is still possible for recycling to not apply. This could happen where pension scheme contributions fluctuate each year because of bonus, overtime or commission payments, where the basis on which the pension contribution is based has not changed.
4. There is a contribution increase to all pension schemes of more than 30% of the tax-free cash payment(s). Note that this includes the situation where money is borrowed or savings are used to pay the contributions, with the tax-free cash being used to repay the borrowing or top-up savings.
5. And finally, the recycling is pre-planned. This means that there was always an intention to increase pension contributions significantly as a result of taking tax-free cash. The pre-planning must take place at the relevant time. If the tax-free cash is taken before contributions are increased, the relevant time is when the tax-free cash is taken. If contributions are increased in anticipation of taking tax-free cash the relevant time is when the contributions were increased.
Here's a couple of examples to illustrate when recycling would and wouldn't apply.
Recycling would apply
On 1 November 2007 Rory took another tax-free cash payment of Â£10,000, again with the intention of significantly increasing pension contributions. The increased contributions amount to Â£10,000. Rory was paying Â£4,000 into his pension scheme each year.
As Rory has received another tax-free cash payment within the previous 12 months, the Â£10,000 has to be added to the previous payment, giving a total tax-free cash payment of Â£19,000. The recycling rule is triggered because:
- Rory specifically took the tax-free cash to pay Â£10,000 back into a pension scheme and receive tax relief, it was pre-planned;
- the total tax-free cash taken in a 12 month period exceeds 1% of the standard lifetime allowance;
- the amount of contribution, the Â£10,000, is greater than 30% of the tax-free cash received; and
- the pension contribution has increased by more than 30% of the Â£4,000 he was already paying.
Recycling wouldn't apply
Rory took a tax-free cash payment of Â£9,000 on 1 May 2007 with the intention of significantly increasing pension contributions. No other tax-free cash payments have been paid to Rory in the previous 12 months.
The recycling rule isn't triggered as the tax-free cash is less than 1% of the standard lifetime allowance, which was Â£16,000 in the 2007/08 tax year.
So, all of the conditions that trigger recycling are met. As a result, the second tax-free cash payment is treated as an unauthorised member payment.
Unauthorised member payments
Unauthorised member payments are subject to tax, which may include:
- a charge of 40% of the tax-free cash paid;
- an unauthorised payments surcharge of 15% of the tax-free cash paid;
- a scheme sanction charge of 40% of the tax-free cash paid; and
- a de-registration charge of 40% of the total pension scheme assets.
So, it's clear that having a tax-free cash payment treated as an unauthorised member payment is to be avoided.
What should you do?
To make sure that a client does not breach the recycling rules you need to identify:
- total tax-free cash paid to the client in the last 12 months and whether this is more than 1% of the standard lifetime allowance,
- if your client wants to take more tax-free cash you need to determine if this will take total tax-free cash payments received in the last 12 months above 1% of the standard lifetime allowance, and
- the amount of contributions paid by, or on behalf of your client, in the current tax year, and in the previous two tax years.
This information will enable you to advise your client to increase their pension contributions or not. As we've seen, it might not be a good thing for them to do, and given the possible tax charges, they won't feel good about it after they've done it. They need you to do your bit and advise them appropriately.
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