Are you tempted to withdraw tax-free pension money before the budget? Beware of this nasty, little-known trap…

Savers who panic with tax-free cash withdrawals ahead of the budget could fall foul of pension recycling rules if they decide to put the money back into their pot later, money experts have warned.

HMRC can charge up to 55 percent of your lump sum if it decides you’ve exploited a little-known trick to get extra tax relief.

Savers have been contacting their pension providers (and This is Money) en masse over fears that the government will tighten the rules for tax-free lump sums in the budget on October 30.

Our pensions columnist, Steve Webb, answered a reader question just after the election about possible changes to tax-free lump sums and whether it was a good idea to put them before the Budget.

However, money experts have warned savers that they could regret taking tax-free cash ahead of the Budget because you could miss out on investment growth under the tax protection of a pension in the future.

Getting caught out in the pension recycling rules is another consideration to take into account. If you’re tempted to take out tax-free money before the budget, put it back if there are no changes anyway because the recycling penalties are so high.

“There are rules in place to stop people taking out money tax-free and then reinvesting it in their pensions, which is known as recycling,” says Clare Stinton, head of workplace savings analysis at Hargreaves Lansdown.

“If you start working with your tax-free money – taking it out and putting it back in – you can get a hefty tax hit.”

How does pension recycling work?

“Pension recycling is the act of reinvesting some or all of the tax-free money into the pension to maximize tax relief,” Stinton explains.

‘The idea is that by paying the money back into your pension, you can generate additional tax relief and possibly build up the right to more tax-free money again.’

She warns that there are limits to HMRC’s generosity. This is because you received tax relief when the contributions were originally made, paid no tax on the withdrawal, and then went back for more tax relief.

‘This is where they draw the line, and it may be one that you unknowingly cross.

‘Limited recycling of tax-free cash is possible. However, if people are caught on the wrong side of the recycling rules, they could face a significant fine that is likely to outweigh any potential benefits.

“The tax-free money will be treated as an unauthorized payment.” See the box on the right for the sanctions.

Stinton adds: ‘Recycling rules only apply to your own pension and do not apply if your tax-free money is used to increase someone else’s pension, such as that of a partner or child.’

Please note that when you start tapping into a defined contribution pension for an amount above your 25 percent tax-free lump sum, you can only put aside €10,000 per year and still qualify automatically from then on for tax relief. .

This rule is intended to discourage people from recycling their pension so that they can benefit from tax relief twice.

Pension recycling is ‘complex and a bit messy’

Nick Flynn, director of retirement income at Canada Life, said: “Tax-free cash is widely regarded as one of the biggest benefits of a pension, and any changes announced in the upcoming budget are likely to be controversial.

‘While it is possible to officially take some tax-free money and reinvest it in your pension to effectively recycle it, it is also complex and a bit messy.

‘If you do it wrong, it can lead to an unpleasant tax bill.

‘If you are considering such an approach, make sure you check your amounts carefully and preferably seek specialist financial advice.

“But the costs and limitations may outweigh the potential benefits. In short: proceed very carefully.’

James Jones-Tinsley, technical specialist in self-invested pensions at consultancy Barnett Waddingham, said: ‘We have had direct experience of clients withdrawing their tax-free money ahead of the Budget.

‘However, with the recycling rules in mind, there is also the possibility that a customer can exercise his right to cancel his pension scheme within 30 days after he has done something with his pension.

“For example, this could include withdrawing their tax-free cash, essentially reversing what they’ve done.”

He notes: ‘This doesn’t necessarily take into account the recycling rules and potential fines, as it’s the equivalent of pressing an ‘undo’ button – as long as you invoke the 30-day statutory period cancellation.

‘If nothing is announced in the Budget regarding tax-free cash, we expect to see a number of cancellation requests immediately afterwards and expect other pension providers to experience a similar event that will clearly impact on delivery.’

Jones-Tinsley warns that if people take tax-free cash with them as a preventive measure, and it turns out to be unnecessary and they try to cancel, they may not get their costs back.

“If they are reimbursed, this could impose a significant financial burden on providers who have ‘already done the work’ only to have to undo it again, all at no cost.

“On the other hand, if no refunds are given, it would amount to a government-induced tax on individuals, albeit a small one.”

What actions could put you on the wrong side of the recycling rules?

Clare Stinton from Hargreaves outlines three possible scenarios where someone receives tax-free cash, and explains whether or not he or she is breaking recycling rules

Anticipate possible budget changes

Annie has taken £100,000 of tax-free cash from her pension as she was concerned about the possibility of this being cut in the budget.

She has kept it in a bank account while she decides what to do with it.

She thinks that if the change does not happen in the budget, she will reinvest the entire amount into her Sipp via transfer.

So far she has made contributions of £10,000 a year.

If she were to do this, there is a good chance she would be breaking recycling rules.

The amount of tax-free cash withdrawn is more than £7,500. It is a significant increase of over 30 percent from her previous contributions and represents over 30 percent of the tax-free money being withdrawn.

If it were considered pre-planned, this could be a breach.

Increasing contributions after taking a lump sum

Fran will receive £150,000 tax-free cash on 1 October 2024 and increase her annual contributions to her company pension by £10,000.

This takes her annual contributions from £15,000 to £25,000. Her contributions will remain at that level for the next two tax years.

Because the cumulative value increase of the total contribution is less than 30 percent of the tax-free money, the recycling rules have not been violated.

Reinvest a significant amount in your pension

John receives £60,000 tax-free cash. He plans to use some of the tax-free money to pay off his mortgage and some to supplement his retirement.

In recent years he has contributed £3,000 a year to his pension.

After paying off his mortgage, he reinvests £30,000 into a pension scheme.

However, because this investment was planned in advance, it is a significant increase and represents more than 30 percent of the tax-free money; this falls under the recycling rules.