What are the advantages and disadvantages of taking the tax-free cash from a defined benefit but not index-linked pension? And what counts as pension recycling?

19 July 2021

Question by Sally

What are the advantages and disadvantages of taking the tax-free cash from a defined benefit but not index-linked pension? And what counts as pension recycling?

Answered by Nicola Crosbie

Sally, defined benefits scheme like your plan are becoming rarer than hens’ teeth yet can provide great value for you throughout retirement.

Schemes like these offering guaranteed, inflation proofed and secure income for life are diminishing rapidly. As mortality is increasing in the UK and the prospect of us living to 100 being more likely, income for life rising with the cost of living is an attractive proposition. Their demise has transformed the way we approach our retirement completely. Historically each scheme was established with its own rules and normal retirement age, typically 60 or 65. Under the Pension Freedom rule changes in April 2015, you can, in theory, now access 25% flexibly of your pension as a tax-free lump sum when you reach 55. In practice, it can be complicated to access only the tax-free lump sum component and leave the income untouched. Your pension scheme rules may not permit this. Accessing tax free cash from defined benefit schemes involves commuting income for a lump sum. In simple terms, commutation means the scheme provides a lump sum payment in lieu of periodic payments of pension. So ultimately the income would need to be drawn simultaneously to facilitate this. You can consider transferring to a flexible pension arrangement to facilitate this, but it must be approached with great caution due to the loss of guaranteed income for life, being unsuitable in most cases. I would advise you approach a qualified and regulated pensions specialist advisor to discuss further.

Pension recycling happens when you use your tax-free lump sum, or flexible pension income to increase your new contributions to a pension scheme and receive tax relief. Legislation is in place to ensure that the system to provide tax relief on pension contributions is not abused. Contributions are deemed as those out with your normal expected retirement contribution patterns. To be caught under pension recycling avoidance rules, all the following conditions must be met:

  • You receive tax-free cash from your pension.

  • Due to this, you choose to pay significantly more into your pension than you would usually.

  • The contribution is made either by you, or on your behalf, by a third party or employer.

  • You pre-planned to recycle your lump sum.

  • All tax-free lump sums drawn in the previous 12 months exceed £7,500 since 6th April 2015.

  • 1% of the standard lifetime allowance for events before 6 April 2015.

  • The cumulative additional contributions made are greater than 30% of this tax-free lump sum.

The onus is on the HMRC to prove the pre-planning took place and all 6 conditions have been met. Should one condition not apply, it would not be deemed an unauthorised payment. If recycling is found to apply, it can result in large tax charges. I would recommend you consider taking regulated financial advice around this as it is a complex area of planning and regulation.

Answered by

Nicola Crosbie

Chartered Financial Planner

With 20 years’ experience behind her, Nicola takes a coaching approach to financial advice, helping even the most nervous investors to take control of their financial situation by empowering them to make more confident, positive decisions for the future. Based in Lochwinnoch, Scotland where she is the Director of Moran Wealth Management Ltd, thanks to secure remote-working practices Nicola supports clients all over the UK.