Pension reforms leaves an “open trap door” for 70% tax charge on withdrawals

Accounting, Budgets, Investments, Pensions, Personal Tax l

Thousands of older savers who use the new pension freedoms to pay off debts could be forced to pay 70% tax on withdrawals they expected to be tax-free if they continue to save for retirement, pension experts have warned.

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.

If the taxman catches people “recycling” too much pension money they could be forced to pay a 40% punitive tax on tax-free cash, plus up to 30% in extra penalties – the same level of penalty applied to people who illegally attempt to access their pension before age 55 using so-called “pension liberation”.

The trap is most likely to affect over‑55s who have used the new pension freedoms to pay off debts, such as a credit card or mortgage, while still working and paying into a company pension scheme.

Paying debts is the most common reason for over‑55s to access their funds under the new freedoms, which were introduced in April to give people more options over how they spent their pension pot.

To fall foul of the rules savers would need to have taken a tax-free lump sum of £7,500 or more (smaller sums are exempt). As you are allowed to withdraw a quarter of your savings tax-free, this equates to a pension worth £30,000, which is about the value of the average British person’s fund.

If savers then use money that they were previously using to make debt repayments to increase their pension payments by more than 30%, they face being charged the 70% fine.

Savers who take this course of action could be deemed by HMRC as having “deliberately pre-planned” to take advantage of the tax system.

A number of financial advisers have already raised that they have managed to stop most clients who were about to overpay into their pensions. However, as many people in their 50s, 60s and 70s, especially those with pension savings of just £30,000 or so, do not have access to professional advice, it is thought that thousands may have unwittingly incurred a 70pc tax bill.

Although the onus is on savers to declare their own tax affairs to the Revenue it is thought that HMRC is able to look at tax-relief claims that providers make on behalf of customers and identify where savers have taken up their 25% tax-free cash at the same time as significantly increasing pension payments.

A spokesman for HMRC said: “The recycling rules prevent the exploitation of the pensions tax rules to generate artificially high amounts of tax relief by using the pension commencement [tax-free] lump sum to make a further tax-relieved contribution into a registered pension scheme.

“As part of the flexibility changes the minimum aggregate value of pension commencement lump sums paid to an individual in a 12-month period that triggers the recycling rule was reduced to £7,500.”

(The above is from an article in The Sunday Telegraph of 6th September 2015)