Pay debts with pension? Avoid this tax trap!

If you are over 55 and thinking of taking money out of a personal pension so you can clear some debts, one of the things you need to be especially careful about is “pensions recycling”. If you accidentally get caught up in these tax rules, HMRC can impose an additional tax charge of up to 70% of your tax-free cash – ouch!

Use a pension to pay off debt – then rebuild pension

There many other good reasons why you should hesitate before raiding your pension to pay off debt, including the tax, charges and other costs you will incur. I’ve looked at these in more detail in Should you use your pension to pay off debts? One of the most fundamental of those is that your pension money is meant to fund your retirement, so if you use it now to solve your debt problems, you may be looking at having too little income for decades when you are retired.

Perhaps you are thinking:

“That’s not a problem – when I have paid off these expensive debts, I will be able to pay much more into my pension each year. I won’t be retiring for 10-15 years, so doing this can solve my debt problem and also let me have a decent pension. I’ll be OK!” 

Unfortunately this is exactly the situation where the pension recycling rules can bite you. As this Telegraph article says:

A little-known quirk in the rules designed to prevent pensioners abusing the tax system means that even over‑55s with modest pensions are at risk of unwittingly breaking official savings limits. Tweaks which mean the rules now affect far more people were quietly made in April this year.

What is pension recycling?

Hargreaves Lansdown has a good leaflet explaining pension recycling. To fall foul of these rules, you have to:

• withdraw over £30,000 from your pension, so that you get a tax-free lump sum of £7,500 or more; and
• then increase your pension contributions over the following years by more than 30%.

The tax-free lump sum that can trigger this extra tax charge was reduced from £12,500 to £7,500 in April 2015 when the pension changes were introduced, in a move that was deliberately planned to stop people taking advantage of the new rules.

These pension recycling rules apply whatever you do with the money you are taking out – build a conservatory, give it to a child for a deposit etc. Here I am concentrating on repaying debts which is a very common reason for people to want to take money from their pension.

Why is the government trying to stop this?

If you are just trying to clear debts, this may all feel very unfair. Why should the government be using this huge tax charge to try to stop you doing a sensible thing?

The answer is that the 25% tax-free cash is meant as an incentive to put money into your pension once. By taking money out, then paying more in for a while, then taking the more out when you stop work, you would be effectively getting more than one tax-free lump sum. There is an extreme example of pension recycling described here.

Put simply, the government intended the 25% tax free lump sum to encourage you to save – not as a way of making it cheaper for you to pay off debt.

How to avoid this punitive tax charge

Well obviously you could find a way of tackling your debt situation that doesn’t involve dipping into your pension – and if this is possible it is very likely to be a better choice for you. However if you are determined to withdraw pension money, the simple way to avoid the pension recycling tax charge is to stay under one of the two key limits:

• withdraw less than 30k from your pension, or
• increase your pension contributions by less than 30% (you can’t increase your contributions by 20% one year and the same the next, as the Hargreaves Lansdown note above explains).

You shouldn’t have a problem if you are in a normal PAYE job, you are currently making the standard pension contributions and you just carry on with this, even if these contributions rise because your salary goes up. However this isn’t going to enable you to rebuild your pension pot that you have dipped into.

If you want to withdraw more than £30,000 and still save a lot more afterwards, you need to take financial advice from a retirement planning expert about whether you would be caught by the recycling rules and what other options you might have, such as using ISAs.