In recent years, new rules have helped millions of retirees access their pension pots more flexibly. The Pension Freedoms legislation revolutionised the way you can draw income from your savings, allowing you to take lump sums, use flexi-access drawdown, or buy an annuity to generate the income you need.
However, with this greater choice has come greater complexity.
In the last five years, more than 1.6 million savers have been affected by a very specific “tax trap”, with new research showing that 1,000 people every working day are falling foul of rules which govern how much you can continue to contribute to your pension while simultaneously drawing from the pot.
Keep reading to find out if this is an issue that affects you, and what you need to think about.
The Money Purchase Annual Allowance restricts your tax-efficient pension contributions
Here’s a simple scenario: you decide to move to part-time working at the age of 60. While the income you generate is sufficient for your lifestyle, you begin to draw your pension flexibly in order to boost your earnings, and to pay for little luxury items.
As you’re still earning a handsome amount, you also want to continue making contributions to your pensions to benefit from the significant tax advantages. Perhaps you’re a higher-rate taxpayer and want to use the 40% tax relief on your contributions?
However, in this situation, something called the Money Purchase Annual Allowance (MPAA) kicks in.
If you hadn’t started drawing your pension flexibly, you could continue to make pension contributions up to the Annual Allowance (100% of your earnings or £40,000 in the 2021/22 tax year) and benefit from tax relief.
However, if you’re subject to the MPAA, you can only benefit from tax relief on up to £4,000 of your pension contributions.
Of course, there is a reason this restriction exists. The MPAA was created to stop people from trying to gain tax relief twice, by withdrawing pension savings tax-efficiently and then paying them straight back in again to benefit from the relief on their contributions.
1,000 pension “dippers” being affected by this tax trap every working day
While this may seem like a minor problem, the truth is that the MPAA has impacted more than 1.6 million people since the new rules came into effect.
260,000 people took their first taxable payment from a defined contribution (money purchase) pension fund in 2020 and so became subject to the restriction – equivalent to more than 1,000 every working day.
If you become subject to the MPAA it could have significant consequences for your future pension savings.
For example, if you are a medium to high earner and you have taken a flexible payment from your pension with the intention of making it up later, the MPAA may prevent you from doing this. Perhaps you wanted to boost your pension contributions in the run-up to your retirement, when your mortgage was repaid, or your children had left home?
Bear in mind also that the recent decision to freeze the MPAA at £4,000 is likely to see more and more people be caught by the restriction. If your contributions are currently just under the £4,000 limit, any pay rises, promotions, or bonuses, could see you exceed this allowance.
And if you or your employer increase your contributions, the MPAA could also kick in.
Finally, triggering the MPAA means you’re unable to carry forward any Annual Allowance from previous tax years, further restricting your tax-efficient contributions.
Taking professional advice can help you avoid this “trap”
There are ways that you can draw income from your pension fund without triggering the MPAA.
If you want to consider boosting your pension savings in the run-up to retirement, you should seriously consider these strategies if you want to continue benefiting from the maximum tax relief on your pension contributions:
- Take a tax-free lump sum and buy an annuity.
- Cash in pension pots worth less than £10,000 and make use of the “small pots” rules.
- Move some of your pension savings into flexi-access drawdown, but don’t take any income from the drawdown scheme.
Remember also that the MPAA only applies to contributions that you make to defined contribution pensions, such as personal or workplace pensions. It doesn’t affect defined benefit (final salary) pension schemes.
Get in touch for expert advice
If you’re thinking about taking a flexible payment from your pension, it’s worth getting professional advice first. We can help you to understand the tax rules surrounding Pension Freedoms and create a strategy for drawing income tax-efficiently.
To find out more, please get in touch. Email info@blueskyifas.co.uk or call us on 01189 876655.
Please note
A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The value of your investments (and any income from them) can go down as well as up which would have an impact on the level of pension benefits available.
Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances. Levels, bases of and reliefs from taxation may change in subsequent Finance Acts.