How to prepare for pension recycling

The government has given more detail on how its pension reforms will work from next April. The most interesting aspect is that it's now clear that there will be opportunities for pension recycling'.

In other words, some folk will be able to take tax-free money from their pension, and then reinvest it back into their pension pot with a further tax break.So how might this work?

First, let's look at the two main options that are being planned for those who want to withdraw large sums from their pension. If you're over 55, your first option from April will be a flexi-access drawdown fund' already christened Fads'.This is similar to the flexible drawdown' we have today.

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Say you have a £100,000 pot. You can transfer it into a Fad, then withdraw the money as and when you see fit. The first £25,000 (25%) you withdraw will be tax-free. After that, you'll pay your marginal rate of income tax on further withdrawals.

If you die before you reach 75, your descendants can inherit your remaining pot, but they may have to pay a 55% tax charge on at least some of it.

Your other main option is to go for an uncrystallised fund pension lump sum (UFPLS). As with flexible drawdown, you have the freedom to withdraw as much or as little as you want. The main difference is that when you withdraw £10,000 from a £100,000 pot, £2,500 will be tax-free, while you'll have to pay income tax on the remaining £7,500.

Then as you withdraw further cash, 25% of each withdrawal will be tax-free. The big advantage of UFPLS is that if you die before you're 75, any remaining money in your pot won't be liable for a death charge'.

Once you start withdrawing, regardless of the method, you can only pay up to £10,000 a year into your pension (rather than £40,000). Still, that £10,000 is significant and may allow you to profit from pension recycling'.

Here's an example: say you're already taking an income from your pension, and your total income is at least £10,000 a year. You can pay in £8,000 to your pension, and if you're a basic-rate taxpayer, the tax office will boost that to £10,000. You can then withdraw this £10,000.

If you're doing it via a UFPLS, you'll get £2,500 tax free and pay 20% tax on the remaining £7,500. So you've had a £2,000 boost from HMRC and paid just £1,500 in tax, making a £500 profit. If you're a low earner you may be able to make an even bigger profit, as you don't have to pay any income tax on your first £10,000 in income.

There are several other similar opportunities for recycling, so it looks like we'll see plenty of schemes along these lines from next April.