A little-known penalty for spending your pension

More and more people are using their pension like a bank account, dipping in as and when to fund large purchases or repay their mortgage. But, there can be a little-known penalty for doing so; a huge reduction in the amount you can tax-efficiently pay back into it. In fact, to date, more than one million people have been subjected to this seriously reduced limit, known as the Money Purchase Annual Allowance (MPAA).

Usually, when saving towards retirement you are subject to the standard Annual Allowance. You can pay in the equivalent of your earnings, up to a maximum of £40,000 a year with tax relief. There are reductions for some high earners and other features such as Carry Forward (rolling over unused Annual Allowance from the previous three years) which can increase the amount you can pay in, but typically your allowance will be £40,000.

The MPAA, however, is just one-tenth of that, at £4,000 a year. That’s the total you can tax-efficiently contribute across all money purchase pension schemes like Personal Pensions SIPPs, and Workplace Pensions, including payments made by you, your employer or a third party.

Why is this happening?

The MPAA usually kicks in as soon as you withdraw a penny more than your 25% tax-free cash entitlement. But, since Pension Freedom rule changes came into effect in 2015, you can now withdraw as much of your pension to spend as you like. Whether you intend purchasing a new car, fitting a new kitchen, or helping your children get on the property ladder, making flexible withdrawals will subject your pension contributions to the MPAA.

Official figures from HMRC show that since 2015, 1,044,000 people have done just that, taking a total of £23.6 billion. Yet, these people might be blissfully unaware that the amount they can now pay back into their pension has been drastically reduced.

From age 55, when it’s possible to make withdrawals, it’s perfectly reasonable to assume you want to continue saving towards retirement for ten or twenty years. Especially considering that we are living longer, working more flexibly and retiring later in life. In fact, a 55-year-old making flexible pension withdrawals and subject to the MPAA would still need to wait 12 years for their State Pension to begin.

Planning is vital

Now you know the MPAA exists, you can take steps to appropriately plan for, or avoid, it all together. The golden rule is to only take flexible income as and when you really need it. Try not to be tempted to use your pension for luxuries, even though you might deserve them!

There are ways you can receive a pension income without triggering the MPAA; by purchasing a lifetime Annuity, for example. However, that solution won’t be appropriate for everyone. Understanding the quirks of our pension legislation means you are able to secure financial security for your retirement. Having a robust financial plan is invaluable.

We make use of cashflow planning to help you visualise your income, expenditure and wealth throughout your lifetime. As tempting as it might be to dip into your pension savings long before you actually intend to retire, we are able to visually demonstrate the effect that it can have in the future.

What if you’ve already been caught out?

If you unwittingly trigger the MPAA, but want to continue saving towards later life, your ISA allowance should be your first port of call. Currently, you are able to pay £20,000 a year into an ISA, which is free of both Income and Capital Gains Tax.

Alternatively, there are other tax-efficient options available such as Venture Capital Trusts, but on occasion, they can come with a higher level of investment risk than traditional pension investments. An increasingly popular alternative is to utilise some of the value tied up in your property via Equity Release, something we are also able to help with.

Ultimately, the knowledge and experience of a Financial Planner can help you navigate the path to retirement with as little fuss as possible, making the most of any opportunities presented and avoiding potential pitfalls like the MPAA.

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