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Pension recycling

We explain the potential tax benefits and the limitations of taking money out of one pension to re-invest in another.

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Ceri Stanaway

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Not to be confused with pension transfers, where you consolidate 2 or more pensions into a single pot, pension recycling is only possible when you reach the age that you can start withdrawing money from your pension. That’s currently 55, though it’s due to rise to 57 from 2028. The idea is that you take money out of one pension and use it to contribute to another scheme. This may seem counterintuitive – after all, why would you take money out of your pension only to put it straight back in? But it can, in theory, offer certain tax benefits, provided you stay within HMRC’s pension recycling rules.

What is pension recycling?

Pension recycling is when you take money out of your pension and use it to make further contributions to your pension pot. In principle, you can recycle any sort of pension income, such as money you’ve withdrawn flexibly from a defined contribution pension (flexi-drawdown pension recycling). But pension recycling is most commonly used in relation to recycling some or all of a tax-free pension lump sum (also known as a pension commencement lump sum, or PCLS). This applies to the 25% of a pension pot that you can withdraw from the age of 55 without paying income tax.

How do I recycle my pension?

On the surface, recycling your pension is fairly straightforward. You simply take money out of one pension and pay it into another scheme, benefiting from the tax relief that is applied to pension contributions. To benefit from tax relief on pension contributions, you’ll need to have some form of relevant earnings other than pension income, such as employment income or certain benefits.

What are the tax benefits of pension recycling?

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By recycling pension income, in principle you can effectively double the tax relief you receive. You will have already had tax relief when you paid the money into the first pension scheme. By taking it out and putting it into another scheme, you get a second load of tax relief. You’ll benefit from continued tax-efficient growth and will be able to take a further tax-free lump sum when you access money from the new pension plan.

And, if you recycle money from your tax-free lump sum, you won’t have paid income tax on the money you withdrew in the first place. Even if you’re recycling taxable pension income that falls outside of the lump sum (such as flexible income from a pension drawdown scheme), the income tax you may have paid could be offset by the new load of tax relief.

While this may sound like a great tax wheeze, some regard it as an ethical grey area. And HMRC has rules in place to prevent people taking unfair advantage of the generous pension tax relief system by deliberately recycling large amounts of their tax-free allowance.

What are the pension recycling rules?

HMRC’s pension recycling rules apply to recycling your tax-free pension commencement lump sum (PCLS). There’s a different set of restrictions for flexi-drawdown pension recycling.

According to HMRC, the rules are designed to prevent the systematic exploitation of pension tax rules to generate artificially high amounts of tax relief.

You’ll fall foul of HMRC’s rules if all of the following apply:

  • You receive a pension commencement lump sum.
  • Because of the lump sum (directly or indirectly), the amount of contributions you (or someone on your behalf, such as an employer) pay into a registered pension scheme is greater than it otherwise would be.
  • The recycling was pre-planned.
  • The amount of the pension commencement lump sum, taken together with any other such lump sums taken in the previous 12-month period, exceeds £7,500.
  • The cumulative amount of the additional contributions exceeds 30% of the pension commencement lump sum.

Some of the points above are clear-cut (whether you took out a pension lump sum, and whether this exceeded £7,500, for example). But others are more open to interpretation – such as whether recycling was “pre-planned”. The onus is on HMRC to prove that pre-planning took place, and HMRC acknowledges that it assesses each potential breach of recycling rules on a case-by-case basis. It has a few examples in its Pensions Tax Manual.

What happens if I follow the rules incorrectly?

If HMRC finds that you have met all of the criteria in the rule checklist above, you will be deemed to have made an “unauthorised payment” into your pension. If this is the case, HMRC can impose substantial tax charges on both you and the scheme (if it was deemed to have knowingly made an unauthorised payment). The charges that you may be liable for include:

  • An unauthorised payments charge of 40% of the tax-free lump sum paid
  • An unauthorised payments surcharge of 15% of the tax-free lump sum paid

You can, of course, try to avoid falling foul of the rules by keeping any additional pension contributions within the amounts outlined in the rules. But even if you exceed these levels, it doesn’t automatically mean you’ve broken the rules. The other factors come into play around intent, and whether your contributions are greater than they “otherwise would be”. You may, for example, have been planning to increase pension contributions from sources completely unrelated to any pension lump sum decisions. HMRC is clear that the rules are not intended to penalise someone’s normal retirement planning.

That said, it’s also possible to get caught out inadvertently, and the rules aren’t necessarily easy for individuals to interpret and follow. If you’re considering recycling some or all of a pension tax-free lump sum into another pension it’s a good idea to seek regulated financial advice. It’s probably wise even if you’re considering increasing your pension contributions from other sources, if there’s a risk these increases could be linked to a lump sum withdrawal.

What are the rules for flexi-drawdown pension recycling?

HMRC’s PCLS recycling rules only apply to money you recycle from a tax-free pension lump sum. They don’t apply to taking taxable, flexible income from a pension drawdown scheme and paying it into another scheme.

However, there are other restrictions in place that limit how much money you can recycle in this way, known as the Money Purchase Annual Allowance. This kicks in if someone with a defined contribution pension scheme either:

  • Starts to draw an income from their pension via pension income drawdown.
  • Takes money from their pension via “Uncrystallised Funds Pension Lump Sum (UFPLS)” withdrawals. This is where, rather than being able to withdraw 25% as a single tax-free lump sum, you leave your money invested and take out smaller lump sums. The first 25% of each smaller lump sum you withdraw is tax-free, the remaining 75% is taxable.

For most people paying into a pension there is an annual contribution allowance of £60,000 (or the level of their annual salary, if this is lower). While you can contribute more than this per year, anything above the allowance won’t benefit from tax relief. The Money Purchase Annual Allowance reduces the limit to just £4,000, which restricts the amount of pension income you’d be able to recycle and benefit from tax relief.

Does pension recycling apply to all types of pension income?

Technically, there’s nothing stopping you from recycling types of pension income other than those we’ve covered above, such as monthly income from an annuity or a defined benefit pension. And accessing your money in these ways doesn’t trigger the Money Purchase Annual Allowance or any other restrictions on making further contributions. But, in practice, these schemes offer much less flexibility over how much you can take out (and re-contribute) compared with drawdown or UFPLS.

Bottom line

In principle, pension recycling can be a good way to maximise tax benefits and boost your pension pot. But it’s a legally tricky area and it won’t be right, or even possible, for everyone. And a misstep could risk a big financial penalty that far outweighs any tax benefits. If you are tempted to try recycling part of your tax-free lump sum, regardless of your reasons, make sure you’re aware of HMRC’s rules and restrictions.

Frequently asked questions

  1. UK Government website

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