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Are you at risk of falling into the pension dipper “tax trap”?

According to figures from HMRC, 260,000 people took advantage of their first flexible pension payment during 2020.

Pension Freedoms allows people to take their pension much more flexibly, but this additional flexibility can have consequences. One little-known tax trap that people accessing their pension flexibly could fall into is the Money Purchase Annual Allowance, or MPAA.

The latest HMRC figures suggest that more than 1,000 pension savers became subject to the strict MPAA every working day by taking their first taxable pension payment from a defined contribution fund.

So, what is the Money Purchase Annual Allowance and how can you avoid falling into this “tax trap”? Read on to find out.

The Money Purchase Annual Allowance can reduce the tax relief available

Introduced in 2015, the MPAA rules are designed to limit the amount of tax relief you can receive on pension contributions you make after you’ve started flexibly drawing your pension.

For example, if you take a phased approach to retirement, you may be in a position where you’ve started drawing on your pension at the same time as continuing to make contributions from your earnings. This is where it’s wise to take note of the MPAA rules.

You receive tax relief on any contributions you make to your pension up to the Annual Allowance (£40,000 in the 2021/22 tax year) or 100% of your earnings, whichever is the lower. This sum includes money you pay in, as well as any payments made by third parties, like your employer.

Once you begin accessing your defined contribution pension flexibly, the Money Purchase Annual Allowance kicks in and reduces the £40,000 Annual Allowance to just £4,000.

This means you’ll only get tax relief on £4,000 of pension contributions, vastly reducing the amount of tax relief you can benefit from.

These money purchase restriction rules only apply to contributions you make to a defined contribution pension. The same rules do not apply to defined benefit pension schemes.

MPAA rules affect people who start drawing their pension while still making contributions

MPAA rules affect pension savers who want to continue paying contributions to their defined pension scheme at the same time as drawing flexible benefits from their pension fund.

The reduced £4,000 allowance applies if you withdraw more than the allowable 25% tax-free lump sum.

The Money Purchase Annual Allowance applies from the day after you have received flexible benefits, any previous savings remain unaffected.

The MPAA only triggers in certain circumstances

The Money Purchase Annual Allowance rule kicks in if you begin taking money out of your pension as flexible income, which you can currently do from age 55 or over.

The MPAA only triggers in certain circumstances, including when you:

  • Withdraw your entire pension pot as a lump sum, in one go, or ad hoc instalments
  • Move your pension into flexi-access drawdown and start drawing an income
  • Buy a flexible annuity
  • Exceed the withdrawal limit for a ‘capped drawdown’ plan.

In most cases, you should be exempt from the MPAA pension limits if you:

  • Withdraw only a lump sum without exceeding your 25% tax-free entitlement
  • Use your pension fund to buy a lifetime annuity
  • Cash in a small pension pot of £10,000 or less.

What about any pension contributions?

If you exceed the MPAA contribution limit of £4,000, a tax charge will be due.

When making contributions to a pension, you usually have the option of carrying forward any unused tax relief from the previous three years. Should you become subject to the Money Purchase Annual Allowance, this carry-forward benefit will no longer apply.

The one thing to remember is that the £4,000 Money Purchase Annual Allowance won’t take effect until you start drawing the taxable part of your pension fund. Until that time, the annual contribution limit of £40,000 still applies.

Avoid the “tax trap” with the right advice

The right guidance can help you avoid unwittingly falling into tax traps like the MPAA.

Pensions expert Stephen Lowe recently spoke of his concerns over the low number of people seeking guidance before taking their first flexible payment.

“Taking tax-free cash from a pension is relatively straightforward but taking taxable income from a pension creates much more complexity,” he said. “The idea that you have the freedom to use your pension like a bank account – paying in or drawing out when you want without any knock-on consequence – is simply not how the system works.”

If you’re affected by the MPAA, it will cut the amount you can add to your defined contribution pension while still benefiting from tax relief to less than £72 a week.

This may cause a problem if you had planned to top-up your pension savings in the run-up to retirement, perhaps when you had repaid your mortgage or your children had left home.

Get in touch

If you’re approaching retirement age and thinking about drawing on your pension, avoid this tricky tax trap with specialist expert advice.

Get in touch today and chat with an independent planner who will help you navigate the pitfalls of the Money Purchase Annual Allowance. Email hello@sovereign-ifa.co.uk or call us on 01454 416653.

Please note

A pension is a long-term investment. The fund value may fluctuate and can go down, 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, tax legislation and regulation which are subject to change in the future.

 

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