In many cases we have helped people take more than 25% Tax Free Lump Sum from the same pension fund. We believe that for some, the new pension rules that come into force in April 2015 will make this solution more achievable by a larger number of people.
The 25% tax free lump sum is one of the most popular benefits of pension saving. We have helped customers who have taken their 25% lump sum (but who do not need an income), to create a further tax free lump sum for the future.
Very simply, we use the income that the customer currently doesn’t want or need, to be used to create a second pot from which a further 25% Tax Free can be taken. The new budget rules make this an attainable goal for more people.
We will discuss how we create this a little later, but some important messages first :
- This solution may not be suitable for everybody – particularly those who want the maximum income in retirement.
- While if you follow our process this will be a tax neutral transaction, you will pay tax on the money you take out of your pension (excluding the 25% tax free amount). The tax will then be reclaimed when you put the money back into your pension fund.
- All income payments out of your pension fund will be paid net of 20% tax; paying the net income back into a pension fund will receive 20% tax relief - therefore this makes it a tax neutral transaction.
- High rate tax payers will account for additional tax payable and tax relief owed via their Self Assessment Tax return.
- The amount where tax relief can be reclaimed on pension contributiuons will be determined by your 'Annual Allowance' (see below).
- We do not offer bespoke tax advice.
- While it is perfectly acceptable and legal to recycle income back into a pension plan, it is against Her Majesty’s Revenue and Customs (HMRC) rules to recycle your tax free lump sum back in to your pension.
- If your pension contributions in any one tax year exceed the Annual Allowance (£40,000 for 2014 – 15) then tax relief on contributions above this amount will cease.
- People recyling income from an Income Drawdown policy started after April 2015 will have their Annual Allowance limited to £10,000.
- The Budget announcement on 16th March 2014 did not discuss preventing income recycling.
- You cannot recycle a Tax Free Pension Lump sum back into a pension fund.
Creating a second Tax Free Lump Sum before April 2015
The example below discusses the method that has been used by some customers to date.
A customer aged 55, who is a basic rate tax payer, has a pension fund worth £100,000. They have no plans to retire until they are aged 65, and therefore do not need an income from their pension fund at this stage.
They place the fund in pension drawdown and take the maximum tax free lump sum of £25,000.
Although they don’t need an income at this stage they nevertheless take the maximum income from their policy.
This income is treated and taxed as earned income and so they can immediately reinvest it back into their pension fund. They decide to do this and as the contributions qualify for tax relief the amount that goes back into their pension is exactly the same as the amount before they took the income out in the first place.
For example if the maximum income they could take in the year was £1,000 then after tax at 20% they would receive £800, direct from the pension company. If they then paid the £800 back into the pension, the pension company would reclaim the tax making the contribution worth £1,000 again.
But why is this important?
What the customer has done by recycling the income is to change the status of the £1,000 within the pension fund. Before they took it out of the pension as income it was part of the original £100,000 pot from which the £25,000 tax free cash was taken. This type of pot is known as ‘crystallised’ and it is not possible to take a further 25% tax free from a crystallised pot.
When they take it out as income and pay it back into the pension it goes onto an uncrystallised pot. This is the important bit - you can take up to 25% of the fund value as a Tax Free Lump sum from an uncrystallised pot.
Based on Pre-April 2015 rules, as the customer in this example has taken £1,000 per annum, and as they have 10 years to retirement, this gives them the opportunity to move £10,000 back into an uncrystallised pot. Assuming the pot hasn’t grown or lost value, then at retirement they could take 25% of this pot (£2,500) as a further tax free lump sum.
Even though in this example you may not consider the figures worth the effort, many people still like the idea of maximising their tax free allowances.
What will be so different from April 2015 ?
Even though all of the talk about the budget changes have been about taking your pension fund as a single lump sum, or a series of lump sums, it should be remembered that everything you take out of your pension fund over and above the 25% tax free lump sum is treated as income and is therefore taxable.
People will think twice about taking it all as a lump sum when they may have to give the tax man somewhere between 20% - 45% of the amount they take !!
However as the amounts after 25% Tax Free Cash are treated as income they can be paid back into a pension fund, and all contributions below the Annual Allowance will receive tax relief at your marginal rate.
For customers who start income drawdown after April 2015, who also take an income from it, they will have a maximum Annual Allowance of £10,000. Customers who started their Income Drawdown policy before April 2015 will have an Annual Allowance of £40,000 as long as the income they take does not exceed a pre-determined limit.
In the example above the customer has a pre-determined limit of £1,000 per annum as income, but from April 2015 no limits will apply – so lets look at that example in a different way.
After taking £25,000 tax free cash the customer is left with £75,000 in their pension fund and 10 years to go before retirement.
With income limits removed, they decide to take an income of £7,500 a year for the next 10 years. Any tax paid is reclaimed making the transaction tax neutral as the amount being taken and recycled is below the £10,000 Annual Allowance.
This means that over the 10 year period they have moved all of the £75,000 from the crystallised pot and put it all in an uncrystallised pot.
This means they can take a further 25% tax free from this uncrystallised pot which equates to £18,750. In other words from a starting fund of £100,000 they have managed to take £43,750 from it completely tax free. This would be the £25,000 at age 55 and the £18,750 at age 65. As the rules currently stand they could again recycle income in the future and take yet another tax free lump sum.
They could keep on doing this until they have taken the majority of the fund as a tax free lump sum. Eventually they may get to the point where the size of the fund means that they take whatever is left as a taxable lump sum.
Obviously in this example, the customer is not using their fund to produce an income in retirement, but they may consider the tax advantages worth taking.