The Pension Loophole
Make money on your pension
Update 6 April 2015: As of yesterday, this loophole no longer works, so don't try to act on it. We've left this guide here as archived information only.
It's not often pensions make you want to dance, but the new rules announced by the Chancellor in his March 2014 Budget have created a 'hokey cokey' loophole which means some people may be able to earn up to £3,000.
To do it you just put your money into a personal pension, then you take it out, then in, then out and shake the cash out. It isn't as easy as it sounds, yet we love this as a mathematical exercise, and think you may find it interesting too. Whether you go ahead is entirely up to you.
This page is ARCHIVED: We've not updated this article for quite a while, but wanted to leave it on the site as it still may contain useful info for you. Please only act on any tips below if you've fully researched them first.
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Only certain people can do this
Ok, this is going to be complicated. So we thought before we even start to explain the loophole, we would tell you who can actually gain from doing this.
That said, even if you can't personally gain from it we're not saying if you're interested in it intellectually don't read on, because it's quite fun (for nerds like us!).
It's also worth noting we're going to present how this works in theory. You'd really need to check your own circumstances and think it through very carefully before putting it into practice.
If you're looking to do it you need to fulfil all of the following four:
- Aged 60 - 75: While the rules for taking your pension are usually aged 55, the bit of the law we're relying on here - small pension pots (more on it later) - requires you to be over 60, but under 75.
- Still be working: To be able to get the tax break here you have to be paying into your pension from earnt income. Therefore, effectively you still have to be working. (This doesn't apply if you don't pay tax, but you can still do the loophole and benefit from basic-rate tax relief.)
- Have a personal pension, or be willing to open one: If you haven't got a pension you need to be willing to get one. If you're not willing to get one, you can't do it. Though exactly what tax you're paying does effect how you do this (see later).
When we talk about personal pensions here we're talking about pensions you set up yourself. Although it might be legally possible to do it with a scheme set up with your employer, it may be complicated and your employer might not allow it, so for ease and control set up your own.
- Have a lump sum of cash: In principle you could dripfeed the money in, but then there is of course the risk the loophole will be closed before you take the cash out. So for the sake of the loophole to work as we describe it put the money in a lump sum so you can take it out straight away.
Remember you can't put in more money than you earn, so to maximise the loophole and put £30,000 in including the tax you'll get as we describe below, that means you need to earn at least £30,000 a year. If you earn less, it'll still work with lower contributions.
While every effort's been made to ensure this article's accuracy, it doesn't constitute advice tailored to your individual circumstances. If you act on it, you acknowledge you do so at your own risk. We can't assume responsibility and don't accept liability for any damage or loss which may arise as a result of your reliance upon it.
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The big picture... how the loophole works
In the 2014 Budget, the Chancellor announced major changes to pensions to take place from April 2015 that will free up the pension regime for people to make their own choice on what they do with their pensions in retirement (see pension changes MSE news summary).
But he also announced transitional arrangements until then, and it's those changes which this loophole is based on. It's not what you can do that is new, just that now you can do it with a lot more money, so it becomes worthwhile.
The key thing this all revolves around is that when you put money into a pension you put it in before tax is taken off. This means...
To save £15,000 in a personal pension, it will only cost a basic-rate taxpayer £12,000 (higher-rate £9,000) in cash because you get the tax you paid on that income back.
So as you can see, your pension pot will be bigger than the amount of cash you put in.
There's nothing extraordinary about this, it's how pensions always work. What's changed though is the fact there are a couple of ways you can now withdraw a decent chunk of it immediately, meaning you're up cash in hand at speed.
"But", I hear you shout, "you still have to pay income tax on pension income so you'll have to pay tax when you take the cash out of your pension!"
Yes, that's true but the rules say you can take 25% of that cash without having to pay tax on it. You have to pay income tax on the rest, but that's only on 75% of the sum. So to sum up how the loophole works...
When you withdraw cash you only pay tax on 75% of the amount taken out, so you'd be up because you pay less tax than you initially gained.
However, if you want to do this you have to take advantage of it before April next year. That's because the new pension rules coming into effect in April 2015 state that once you start drawing your pension, you'll only be able to contribute £10,000 a year.
Because this change has been made we think this loophole is likely to be here for the rest of the year without a problem, although of course, nothing is guaranteed.
Step-by-step guide to the loophole
Remember, the key here is it's fairly easy to put cash in a pension pot and have your pot bigger than the amount of cash you put in. The difficult bit is getting that money out.
The loophole takes advantage of a rule called small pension pots. It says if you have up to three personal pensions with no more than £10,000 in each, you're allowed to withdraw that cash (of course you can only get 25% of it tax-free, the rest of it you'll pay tax on at your standard income tax rate).
So just to be clear:
You can do it up to a maximum of £30,000 per person, with a maximum of £10,000 in each pension pot.
If you have more than three pension pots you can still do the loophole, but only with three.
If you have more than £10,000 in a pension you can't use that particular pension pot for this loophole.
For basic-rate taxpayers and non-taxpayers. To do the full £10,000, you'll need an £8,000 lump sum cash as a basic-rate taxpayer, that's because after tax relief when you put that in your pension, you will get £10,000. We're going to do this assuming you're putting in the full amount. If you're using a smaller amount, then just make the numbers proportionate (remember you put in 80%).
If you don't pay tax you can still do the loophole with up to £3,600. You, or a spouse, child or grandchild, can set up a personal pension and pay in £2,880 - it will get topped up to £3,600 (equal to 20% tax relief) - and because a non-taxpayer doesn't have to pay tax on ANY of the money taken out, it means you'll make £720. There is no tax relief for contributions above this amount.
- For higher-rate and additional-rate taxpayers. To do the full £10,000, you'll also need to put £8,000 in cash into your pension. However, because you're a higher-rate taxpayer you should receive relief at 40%.
You'll automatically get the 20% basic-rate (£2,000), but it's also possible to get the extra relief and you do that by claiming it when you fill in your self-assessment form at the end of the tax year. So that £2,000 (the extra 20%) will come back to you, it will just take a bit longer. Overall though, that means a £10,000 pension will only cost you £6,000.
It works exactly the same for aditional-rate taxpayers, but you'll get 45% tax relief when you put your money in and that's what you'll have to pay when you take it out (apart from on the 25% tax-free lump sum).
Wait until tax has been topped up, this usually takes four to six weeks.
Status (basic-rate taxpayer): You now have £10,000 in a pension, you put in £8,000.
Status (higher-rate taxpayer): You now have £10,000 in a pension, you put in £8,000.
Now the aim is to take the money out of your personal pension. You're allowed to take 25% as a tax-free lump sum, the remainder you pay tax on at your tax rate. So here's how the sums add up...
|Total amount put in||£8,000|
|Amount in pension||£10,000 (incl. £2,000 tax-relief)|
|Tax-free lump sum||£2,500|
|Tax paid (on remaining sum)||£1,500 (20% of £7,500)|
|Total amount taken out||£8,500|
|Gain||You have made a profit of £500 per £10,000|
|Total amount put in||£8,000|
|Amount in pension||£10,000|
|Amount reclaimable when you do your self-assessment||£2,000|
|Tax-free lump sum||£2,500|
|Tax paid (on remaining sum)||£3,000 (40% of £7,500)|
|Total amount taken out||£9,000 (£7,000 + £2,000 tax back from self-assessment)|
|Gain||You have made a profit of £1,000 per £10,000|
Repeat to earn more. As you can take advantage of the small pension pot rules three times, you can repeat steps one to three two more times. You will make £500 each time as a basic-rate taxpayer (although watch out for going over the threshold of becoming a higher-rate taxpayer, more on this later) and £1,000 each time as a higher-rate taxpayer.
MAX GAIN: That means at the end of the small pots process in principle you can make £1,500 as a basic-rate taxpayer and £3,000 as a higher-rate taxpayer.
For the sake of the pension loophole, one of the the best things to do is to set up a personal pension. This could be a low-cost SIPP (a special type of personal pension which offers a wider range of investment choice). This is just a DIY pension, for full information read the Cheapest SIPP guide.
You can set up the SIPP online. When filling out your details make sure you choose to put your money in cash (you DON'T want to invest any of it). Then you'll be able to monitor when the tax has been topped up online, as soon as this has happened you'll be able to withdraw the cash again. The process usually takes four to six weeks, so just keep an eye on it.
You can also set up a traditional personal pension. These can be done through a number of banks and insurers such as Aviva, Legal & General and Standard Life. The difference between a traditional personal pension and a low-cost SIPP is the range of investment choice available and the different charging structure when investing. But as for the pension loophole you don't want to invest the money anyway, they are both adequate for this purpose.
We'd suggest that if you're doing this, the main thing you want to look out for when choosing a provider to start your personal pension with, is one that doesn't have any annual charges.
You're only going to be leaving your money in there for a couple of months and you're not investing, so you don't need to choose a provider based on that.
Self-assessment is where you fill in a form to tell the taxman how much tax you're going to pay for the year. Higher-rate taxpayers can claim an extra 20% tax relief on pensions through their self-assessment tax-return that has to be returned to HMRC in January every year.
If you're filling out a paper form, the section of the form you need to get the tax relief is called: "Pension savings tax charges and taxable lump sums from overseas pension schemes”.
You may need to provide your pension scheme tax reference number, which should be on any paperwork you receive. If not, you can get it from the provider of the pension.
Yes. The trivial commutation rules state that if you have a pension that has up to £30,000 in it, you can withdraw this money as a lump sum, although you will have to pay tax on some of it as you do with small pots. So in principle the same rules apply as with the small pension pot loophole.
However, you're only allowed to do trivial commutation once and combining this with small pots would mean that you go over a threshold and break what are called 'anti-recycling' rules. That's why we've just stuck with explaining small pots. .
The maximum amount that can be put into any type of pension in a year is £40,000. If you go over this you may face a tax charge on some, or all of the money.
In principle for the sake of this loophole, where you need to earn and contribute at least £30,000 to max it out, it's fine. You only need to be careful if you're already contributing money to other pension schemes that would push you over the limit.
If you're also taking other pension money out that year you could fall foul of the anti-recycling rules. The anti-recycling rules are there to stop people taking tax-free cash and putting it straight back into a pension to get further tax relief on it.
The rules only apply if the tax-free cash is more than 1% of the lifetime allowance (basically the total amount of cash you can whack into a pension in your lifetime) and this limit is a whopping £1.25m for 2014/15.
What we're calling the 'remaining sum' - ie, the taxable part of the money taken out - in the tables above also counts towards your taxable income. So three maximum lump sums will count as £22,500 of taxable income, add that to the earnings you need of at least £30,000 and it will push you over the threshold for higher-rate tax - £41,865 in 2014/15 (based on a personal allowance of £10,000. If you were born before 6 April 1948 your calculations will be different).
This means depending on any other income, just doing two small pension pots, or even one, might also push you over the limit.
If you're already a higher-rate taxpayer then this issue shouldn't affect you. Both your earnt income, and the money taxed as part of the loophole, is taxed at the higher 40% tax rate. It would ONLY affect you if you're near the £100,000 mark as you'd be paying more tax (your personal allowance will be reduced).
This may affect you. What it means, is that some of the taxable money taken out may be taxed at the higher 40% rate and not 20%, even though you might be a basic-rate taxpayer in terms of the salary you earn. This makes the calculation and how much you can make from this loophole much more complicated as your tax status all depends on two things:
How much you earn
How much you want to put in
The simple(ish) way
This is all about making sure you never go over the threshold to become a higher-rate taxpayer. Lets show you how this could work with an example.
Susie earns £30,000 a year (with no pay rise or bonus). This means she can then 'earn' up to £11,865 before she becomes a higher-rate taxpayer, that's equal to putting in £12,656 into a pension - max one and a half pots. If you want to work out your income tax, use the Income Tax Calculator. The table below breaks it all down:
|Total amount put in||£12,656|
|Amount in pension||£15,820|
|Tax-free lump sum||£3,955|
|Tax paid (on remaining sum)||£2,373|
|Total amount taken out||£13,447|
|Gain||Susie has made a profit of £791|
The complicated way
This is so complicated we won't even attempt to put it into a table! Some people will tip over into being a higher-rate taxpayer after doing the first pot, so will then make more doing the second and third.
This will happen to other people on the second or even third pot. But for others, they could even end up making a loss rather than a profit. If you're unsure and not great at working out the maths on your own, stick to the simple(ish) way.
If you want to do it you could always speak to a financial adviser - but you'll obviously also lose money here by paying them.
Is it legal? Is it moral?
A message from Martin - Is it legal? Is it moral? It's certainly legal. As for moral? That's tough, you're using the system as it's designed, but not as it's intended.
The profit, of course, comes from the general tax pot, so... it's not clear cut. You need to think it through. I did wrestle with whether to cover this. In the end I was swayed for a few reasons:
I'm a nerd, and the sheer pleasure of the mathematical puzzle behind this is just too appealing.
I've seen it discussed elsewhere, a few times in complex tones, only for those with big bucks. If there's going to be a loophole, I thought MSE should democratise it and give everyone who it suits the choice.
On the back of the above, if we publicise it the likelihood is it'll be closed sooner, not necessarily a bad thing.
Yet we would suggest that you think carefully before doing this. Certainly if you're going to do it, do it carefully, as it is complex - and understand that there's a risk.