George Osborne won lavish appreciation after he jettisoned pension regulations that effectively forced people at retirement to purchase an annuity. Annuities-- where you provide all your pension fund savings to an insurance based business in return for a regular income-- are (or were) amongst the most detested of all financial products.
In liberalising the guidelines, Osborne opened up a possibly amazing tax loophole. It is called "pensions recycling" by the market and this is how it works.
Among the immediate changes Osborne announced were to the "trivial commutation" guidelines, which sounds like degree-level pension planning-- and it is a bit-- but remain with me. If you had less than £ 2,000 in any old pension pot (say, from a previous employer) the old guidelines let you take it as money in one go, without needing to purchase an annuity. But the £2,000 ceiling has actually been raised to £10,000. Of that, the individual can take 25 % as a tax-free lump sum amount.
We have been helping recycle pension income for many years, but now things are a lot simpler for people to comprehend – especially for high rate tax payers. Why not pay £10,000 into an income drawdown pension plan-- and get 40 % tax relief, so it just costs £6,000. Then take it all out including your £2,500 tax-free cash lump sum. Then put the remaining £7,500 back into a pension pot (after all, you've not been required to buy an annuity), cash it in a year later, secure a further 25 % tax-free lump sum - another £1,875-- then throw the rest back into a pension, and let the merry-go-round continue. The recycling of the 75% is tax neutral – while you pay tax on any money you take out of a pension, the moment you pay it back into a pension plan you get the tax back !!
You'll pay no income tax and national insurance on your profits as you feed your pension, and after that get tax-free payments equating to 25% of the pension fund value when you withdraw it. From next April, when complete liberalisation begins, millions of people could do this, recycling their pension money and getting one over on the taxman.
The Finance Act 2006 introduced "anti-avoidance provisions to avoid tax free lump amounts taken from pension being made use of to fund additional tax-relieved pension contributions". However this has never applied to income taken from a pension plan as income is taxable. Before these new rules while some customers were recycling income back into their pension plans to create further tax free lump sums in the future, the pension rules limited them on how much income they could take from their fund each year – the new rules remove all income limits, so it will be possible to take it all on one go if you wish. This is where the new opportunity exits.
The issue is that liberalisation has significantly expanded the scope for recycling and the temptation for customers to use the new rules to their financial advantage is compelling. But will the government allow this situation to continue, or will they feel it is a loop hole than needs closing ?
Pensions expert Bob Cook of Best Pension Annuity and its sister company Best Drawdown Pension said “Many customers have been recycling income for several years, and Her Majesty’s Revenue and Customs (HMRC) have been well aware of the practice. Furthermore the number of customers actually recycling is comparatively small when compared to the rest of the market. For those customers already recycling the annual allowance is £40,000 per annum – 4 times the new limit, if those customers don’t vary their pension contracts when the new rules come into place then they can retain the £40,000 limit, while customers new to recycling will be limited to £10,000. This significant reduction in how much can be recycled may be sufficient to allay any HRMC concerns.
“However if there is a significant increase in customers choosing to recycle, then that may prompt HMRC to seek ways of outlawing the practice. My understanding is that the Treasury is captured between wanting to liberalise pension rules on the one hand, and making signififciantly more for themselves on the other, by possibly having to enforce an entire load of new guidelines to stop what it may consider to be abuse of the system.
“What is important to remember is that recycling is currently legal and nothing yet in the new pension legislation is set to rule it out. Personally I believe that whatever future legislation is put in place, it may be difficult for HMRC to make pension recycling disappear entirely.