Income in a spin

Adrian Walker discusses the benefits of income recycling

Recycling money into a pension is a concept that many advisers will be aware of, although it’s likely that advisers will be more in tune with the restrictions around this as opposed to the benefits that pension income recycling can have when done within the rules set out by HM Revenue & Customs (HMRC).

HMRC’s anti-avoidance measures introduced in 2007 were aimed at restricting clients from recycling a lump of tax-free cash into their pension fund. Despite the restrictions on recycling tax-free cash greater than £18,000 in the 2010/11 tax year) the recycling of income taken from a pension remains allowable under HMRC rules.

There are many reasons why clients approaching retirement may decide to access their personal pension before they officially retire from work and take an initial lump sum of tax-free cash. Clients in this position will already be of legal retirement age. If the client stays in work they may not need to take an income from the pension once the tax-free cash is taken.

Clients who access their pension funds may wish to keep better control of their investments and maintain a level of flexibility that is not traditionally found by purchasing an annuity. Clients in this position would be well placed to move the savings left in their pension fund into income withdrawal.

By placing the remaining capital into income withdrawal the pension fund will:
• Produce income in retirement on which income tax will be payable at the client’s applicable rate of income tax.
• Be subject to a 35% tax charge or provide income for one or more dependents should the client die before securing a lifetime annuity.
• Continue to benefit from investment growth if the client decides to defer taking the annual income entitlement completely.

Most clients in this position will have built up pension funds that are well below the lifetime allowance of £1.8 million in the 2010/11 tax year. In addition, some clients will not be making tax-relievable contributions at the maximum level allowed (i.e. 100% of their relevant earnings).

Clients that opt to take their pension commencement lump sum and go into income withdrawal may not realise the potential longer term benefits of taking an income from the fund and then recycling it back into the fund in order to grow a new tax-efficient lump sum of money that can be accessed at a later date.

Client benefits

Clients who do not need to take an income should consider taking one anyway, as building a new pension fund from an existing income withdrawal arrangement can provide efficient retirement planning and can benefit clients in the following ways:
• The new contributions created from the income taken will effectively create a new pension fund which allows a further tax-free lump sum withdrawal of 25% in the future, which otherwise would not be available. When doing this the client is able to access these new benefits at any time before their 75th birthday.
• If the client dies before age 75, and before accessing any further benefits, the lump sum death benefit paid from the new contributions fund (ie. the recycled income) would not be subject to the 35% tax charge applied to unsecured lump sum death benefits. By taking income withdrawals to create the new contributions, the proportion of the client’s pension fund eligible to be taxed at 35% tax charge would be reduced.

Income tax will be payable on any income drawn from an income withdrawal fund above the personal allowance of £6475. The client will then receive income tax relief at the same level on any contributions made back into the pension. Effectively, this planning provides a neutral income tax position for the client.

Clients who are higher rate tax payers at the time of drawing income from their pension may suffer from a short term cash flow shortfall as they will be charged higher rate tax when the income is taken, but will only get basic tax relief when the income is recycled back into the pension. This can be resolved by claiming any higher rate relief directly from HM Revenue & Customs.

This planning can be used by any clients who are not taking their full income entitlement from their income withdrawal arrangements. Clients who have fully retired and are receiving no regular income will only be able to recycle a gross contribution of £3,600 a year.

Clients who do draw an income from their pension and then recycle the money back into the pension will reduce the income withdrawal component of their fund over time.  This will ultimately have the effect of potentially reducing their maximum annual income when the formal five-year income review is required. At this time the client can either:
• Add the untouched fund (formed of recycled income) back into their income withdrawal fund and take another pension commencement lump sum, or
• Leave the fund untouched and adjust any ongoing contributions in line with income requirements and new annual income limits.

The current economic climate has provided a number of significant opportunities for clients to boost the amount of annual income available from their existing income withdrawal fund. For example, over the last 12 months there has been a significant recovery in the major investment markets of the world which will have increased the size of many invested income withdrawal funds. This, coupled with a slight, but consistent increase in gilt yields, will leave many clients better off than they were 12 months ago.