Reinvesting your pension money is a sneaky way to boost your pot - we explain how it works
Now that savers aged over 55 can access their pension savings in one go, tens of thousands of older people are choosing to take cash from their retirement pot to spend on anything from debt repayments to round-the-world cruises.
For those in the know, a number of attractive loopholes also come into play, which – if used smartly – can be used to increase your income in retirement.
One of the best things about pensions is the attractive tax relief you get when you pay into one. You can carry on benefiting from this even when you’ve retired, although only with strict caveats.
If you’re going to “recycle” your pension money you must do so with extreme caution. If you fall foul of the rules, you could end up with a huge tax bill instead of a small one.
Here we answer common questions on how you can “recycle” your pension money.
How does recycling work?
The theory of recycling is that investors pay into their pension and therefore benefit from the tax relief (paid at the taxpayer’s rate of 20pc or 40pc), and then immediately withdraw the money. It’s a neat turn, all executed at no risk to the saver and entirely at the taxman’s expense.
For every £1,000 paid into the pension of a basic-rate taxpayer, £200 (20pc) comes from the taxman. So your £800 cheque benefits from an instant 25pc (£200) boost.
And if you’re a 40pc taxpayer, there’s even better news: the instant returns you can get just by funnelling some money into your pension are even greater. This is because for every £1,000 paid into the pension of a higher-rate taxpayer, £400 (40pc) is paid by the taxman. So your contribution of £600 is boosted by just over 66pc (£400).
The only slight annoyance is that you must claim back higher-rate tax relief on pension contributions by filling in a self-assessment form, whereas basic-rate tax relief is credited automatically by your pension scheme.
How much can I safely recycle every year?
If you’ve got a “capped drawdown” arrangement that you took out before 6 April this year, and you withdrew at least a penny from it as pension income before that date, you’ll be able to continue investing up to £40,000 a year into it – the normal “annual allowance” for pension contributions.
If you have a capped drawdown pension and you haven’t yet taken any money from it as pension income, you’ll have lost the higher £40,000 limit and you’ll be allowed only the new limit of £10,000 a year. Likewise if you have a “flexi drawdown” arrangement set up after 6 April this year, you’ll be allowed to contribute only £10,000 a year into it in future.
You can contribute only as much as you earn in any given year. Income from your pension unfortunately doesn’t count towards this.
I’m retired and not working. Can I still recycle?
Yes. Say you are over 55, have finished work and are living off savings. You can still invest up to £2,880 per year into a pension, attracting basic-rate tax relief by doing so. This will bring your total pension contribution up to £3,600, giving you a 20pc return on your money.
The money can be withdrawn right away, depending on the terms applied by your pension provider. The first 25pc (£900) is tax-free, and the rest is taxed as income.
Remember that you can earn £10,600 in the current tax year without paying tax, so if you’re a non-earner you’ll be able to take the whole lot without paying any tax. You can repeat this once a year.
I’ve heard I could be taxed at 70pc if I recycle too much. Is this right?
Yes. Since the freedoms were introduced, a number of retirees have decided to use all or part of their pension cash to increase their ongoing pension contributions either directly or indirectly. One common way is to pay off debt and then use the income released (the money you previously used to make regular debt repayments) to pay more into your pension.
This may sound like good financial planning but it’s surprisingly easy to fall foul of the recycling rules. A little-known quirk could result in your original withdrawal being treated as unauthorised, which can incur a tax charge of 70pc.
Two things must happen for your withdrawal to count as unauthorised. First, the tax-free cash you took in a particular tax year has to be more than £7,500. Second, your pension contributions over five years have to be more than 30pc of the value of your tax-free lump sum. The five years that matter are the two years before the withdrawal, the year of the withdrawal itself, and the two years after it.
You don’t even have to make the contributions yourself for them to count; even if they are paid by someone else, such as an employer, they will count against you.
How is the 70pc tax calculated?
If your contributions failed the two tests outlined above, the whole of your tax-free cash would be deemed to be an unauthorised payment.
The withdrawal would trigger an unauthorised payments charge of 40pc and possibly another fine called an “unauthorised payments surcharge” of 15pc. Your pension scheme would then be charged a “sanction charge” of 15pc, bringing the total to 70pc.