RPSM04104990 - Technical Pages: Taxation: Unauthorised Payments: Recycling of pension commencement lump sums: Examples

Examples to illustrate when the recycling rule does not apply

Example 1 - Change of employee contribution level on moving to new employer

After 20 years, an individual leaves Employer A and takes a pension commencement lump sum from Employer A’s registered pension scheme. During the membership of that pension scheme as an employee, the individual was not required to make any contributions and nor did the individual ever make any voluntary contributions or any other private pension contributions. Apart from the benefits from Employer A, the individual has no other pension saving.

Before leaving Employer A, the individual applied for and got another job with Employer B, who has a registered pension scheme to which that individual would have to pay contributions as a condition of membership. On leaving Employer A, the individual takes up the job with Employer B and joins Employer B’s pension scheme, as intended.

As the individual is simply paying contributions out of that individual’s salary from Employer B in the ordinary course of the membership of Employer B’s pension scheme, the contributions are not significantly greater than might have been expected.

Example 2 - Consistent basis of contributions with fluctuating salary levels

A member’s annual contributions to registered pension schemes have fluctuated in the 5 years (years 1 to 5) leading up to the year in which the member takes a pension commencement lump sum (year 6). The contributions in year 6 are £15,000, which is an increase of more than 30% on the previous year’s contributions of £10,000 (£10,000 + 30% = £13,000).

However, although the member’s contributions in years 1 to 5 have fluctuated, the basis on which they were calculated has not changed. The contributions were based on a set percentage of the member’s salary, which has, itself, fluctuated because that salary includes bonus payments on the following basis:

Year 1 - bonus paid

Year 2 - bonus paid

Year 3 - no bonus paid

Year 4 - bonus paid

Year 5 - no bonus paid

Year 6 - bonus paid.

Although the member’s contributions have increased by more than 30% between year 5 and year 6, the amount of increase - £5,000 – does not represent a significant increase. This is because the contributions for year 6 are paid on the same basis as the contributions paid in years 1 to 5 so the amount of the contributions is not more than 30% more than the contributions that might have been expected.

Other circumstances where contributions might fluctuate but are still paid on a set basis are where a member pays contributions each year equal to the amount of the member’s UK earnings that would ordinarily be over the threshold for higher rate tax or where contributions are based on a percentage of self-employed profits.

Example 3 - Consistent basis of contributions

In the same year that an individual receives a pension commencement lump sum, the contributions into a registered pension scheme for the individual increase from £10,000 to £15,000. The amount of the increase - £5,000 – means that the individual’s contributions have increased by more than 30% (£10,000 + 30% = £13,000).

However, the increase is not a significant increase as the individual’s contributions – paid both by the individual and the individual’s employer – are paid on a consistent basis. Since joining the employer 3 years ago the combined rates of the employee and employer contributions were 10% of pensionable salary and the individual’s salary increased by an average of 4% a year over that time.

In the year in which the individual took the lump sum, the contribution rate remained at 10% but the individual moved to a different position with the employer that meant that the individual’s pensionable salary increased considerably; from £100,000 to £150,000 a year.

Although the contributions for the individual have increased by more than 30% in the year in which the lump sum was paid, the amount of increase - £5,000 – does not represent a significant increase. The basis on which the contributions were paid remained the same, and so the contributions were not significantly greater than might have been expected.

Example 4 - Use of RPI adjustments

An individual takes a pension commencement lump sum and then pays contributions into a registered pension scheme. The contributions - £7,000 - are the first such contributions by, or in respect of, the individual for the last 5 years.

The last contribution that was paid into a registered pension scheme in respect of the individual was paid 6 years ago and amounted to £5,000. Allowing for an adjustment to take into account the increase in the Retail Prices Index (RPI) since that contribution was paid the equivalent value of that contribution at the time that the lump sum is paid is £6,000.

The amount of contributions paid after the lump sum was taken - £7,000 - represents an increase of more than 30% on the contributions that were last paid in respect of the individual (£5,000 + 30% = £6,500). However, there has not been a significant increase in contributions. This is because when the increased contributions (£7,000) are measured against the last contributions, as adjusted to allow for RPI increases, the amount of the increase is now less than 30% (£6,000 + 30% = £7,800).

(As the previous contribution was 5 years earlier, RPI is used to produce a “current value” for comparison purposes. The use of RPI to produce a “current value” will only be necessary where there is no pattern of contributions.)

Example 5 - Increase in employer contributions unconnected with lump sum

For the last three years, a member of a registered pension scheme has been required to pay annual contributions at a rate of 4% of pensionable salary. The member’s employer, historically, has paid contributions at a rate of 8% of pensionable salary but has not paid any contributions over the same period as the funding of the scheme allowed a contribution holiday.

The member, whose pensionable salary is £35,000, takes a pension commencement lump sum from a different scheme. At the same time, the results of a contribution review mean that the employer ends its contribution holiday and the rate of overall contributions must be increased. The employer’s contribution rate recommences at 9% of pensionable salary and the employees’ contribution rate is increased to 6%. This represents an increase in contributions of £3,850 – current contributions of £5,250 (£35,000 x 15%) less the previous contributions of £1,400 (£35,000 x 4%).

Although the new contribution rate relating to the employee - 15% of pensionable salary – means that the amount of contributions have increased by more than 30%, this does not represent a significant increase in contributions. This is because, in effect, there has not been a material change in the basis on which the contributions are paid by and in respect of the member, and so the contributions are not significantly greater than might have been expected. Although the overall rate of both the employer’s and employees’ contributions has actually increased, that increase is a consequence of prevailing employment conditions and has not been influenced in any way by the taking of the lump sum.

Example 6 - Illustration of the cumulative basis

In the tax year (year 1) in which a pension commencement lump sum of £35,000 is received by a scheme member, who intended to use that lump sum to increase contributions to a registered pension scheme, the contributions to registered pension schemes relating to that member increase from the previous 10 years’ annual contributions of £10,000 to £10,500 – as it is an increase of 5%, the amount by which the contributions have increased in that year is not a significant increase.

In the following tax year (year 2) the contributions increase to £11,000 – an increase of 10% on the usual contributions of £10,000 for that year (the amount of annual contribution that would have been expected before the payment of the lump sum). This is not a significant increase as the £1,000 increase, in itself, is less than 30% of the usual annual contributions and the £1,000 increase and the increase in year 1, together, do not exceed the 30% limit (year 1 increase of £500 plus this year’s increase of £1,000 = 15% of the amount of usual annual contributions of £10,000 for year 2).

In the next following tax year (year 3), contributions increase to £12,000 – an increase of 20% on the usual contributions of £10,000 for that year (the amount of annual contribution that would been expected before the payment of the lump sum). This is now a significant increase in contributions as, cumulatively, the amount of the increase - £3,500 – is more than 30% of the amount of contributions that might be expected in that year (year 1 increase of £500 + year 2 of £1,000 + this year’s of £2,000 = 35% of the usual annual contributions of £10,000).

However, the recycling rule is not triggered as the significant increase in the member’s contributions - £3,500 – does not exceed 30% of the amount of the pension commencement lump sum (lump sum of £35,000 x 30% = £10,500).

RPI is not required because the “current value” of contributions was £10,000.)

Example 7 – payment of regular contributions

An individual is a member of two registered pension schemes. The member must pay a set rate of contributions as a condition of membership of scheme A and takes a pension commencement lump sum from scheme B. The ongoing contributions to scheme A will not trigger the recycling rule if the member did not pre-plan to use the lump sum as the means to significantly increase the amount of those contributions to scheme A.

Similarly, if the member was also paying or planning to pay additional voluntary contributions to scheme A (or possibly to an entirely different scheme – scheme C), those contributions will not be caught by the recycling rule if the member did not pre-plan to use the lump sum as a direct or indirect means to significantly increase the amount of any additional voluntary contributions.

Example 8 – an inheritance

A member takes a pension commencement lump sum. Soon after, the member’s uncle dies, leaving the member an inheritance. Because of the unexpected inheritance (and not because of the pension commencement lump sum), the member decides to make a one-off contribution into a registered pension scheme of the amount of the inheritance (or less). That contribution will not trigger the recycling rule because the member did not pre-plan to use the pension commencement lump sum as a means to pay significantly greater contributions into the registered pension scheme.

Example 9 – contributions based on profits from a self-employment

An individual receives a pension commencement lump sum as part of retiring from an employment. The individual then concentrates on a self-employment and decides to use 10% of each year’s profits to fund contributions into a new registered pension scheme. Therefore, some months after receiving the pension commencement lump sum the individual pays the first contribution into this new registered pension scheme. That contribution will not be regarded as caught by the recycling rule because the contribution is made because of the self-employment and is not part of a device to recycle the lump sum. The member did not pre-plan to use the pension commencement lump sum as a means to pay significantly greater contributions into the registered pension scheme.

Example 10 – genuine windfall

A member sets in motion the payment of a pension commencement lump sum from a money purchase arrangement.

Whilst waiting for quotes on the value of the units that comprise the member’s money purchase arrangement, the member has a substantial lottery win.

Following receipt of the unit valuations in the meantime, the pension commencement lump sum can be paid. The member decides to take the lump sum in order to clear some existing debts, as planned. When the lottery winnings are received, the member pays a substantial contribution into a registered pension scheme, of an amount equal or less than the lottery winnings. That contribution will not be regarded as caught by the recycling rule because the member did not pre- plan to use the pension commencement lump sum as a means to pay significantly greater contributions into the registered pension scheme. The contribution is made because of the lottery win and not because of the lump sum.

Example 11 – Financial settlement

An individual receives a payment following a financial settlement (such as a settlement on divorce/dissolution of a civil partnership or a compensation settlement). The member decides to pay some of that financial settlement into a registered pension scheme. At around the same time the member receives a pension commencement lump sum from a registered pension scheme. The contribution will not be regarded as caught by the recycling rule because it was made because of the financial settlement and not because of the lump sum (the individual did not pre- plan to use the pension commencement lump sum as a means to pay the significantly greater contributions).

Example 12 – Employer buys an immediate commencement annuity

An individual has been in non-pensioned employment but has nevertheless made private money purchase pension provision in a registered pension scheme. Leading up to retirement from the employment, the individual asks for valuation quotes for the money purchase fund in order to consider what benefits will be drawn from the pension saving.

The employer decides to reward the individual with an annuity after all, which will be achieved by way of a registered pension scheme. The member takes a pension commencement lump sum from the private pension provision.

The contribution by the employer for the annuity is not a recycled contribution provided that the amount of the intended contribution toward the annuity awarded by employer has not been increased to any extent as a consequence of any agreement between the individual receiving the annuity and the employer that would have involved the individual using the pension commencement lump sum as means of increasing the employer’s contribution toward the annuity the employer is to provide for the individual.