Flexible pension withdrawals continue to rise in popularity according to HMRC, hitting new records in the second quarter of 2018 for the number of people making them, the sheer volume of withdrawals and the ultimate value; reaching almost £2.3 billion.
That is a significant sum of money being taken out of pensions in a short timeframe, but what are the implications for people wanting to make withdrawals and continue to plan for retirement, paying contributions back in?
The Money Purchase Annual Allowance
There is an allowance on the amount you can tax-efficiently save in pensions each year (called the Annual Allowance), currently set at an absolute maximum of £40,000. There are other restrictions, dependent on your level of income amongst other things, but what we’re going to focus on is what’s known as the Money Purchase Annual Allowance (MPAA); a severely restricted tax-efficient contribution limit of just £4,000 a year.
The MPAA is triggered when you begin to;
- Take ad-hoc lump sums
- Go into Flexi-Access Drawdown and start to take a regular income
- Purchase a flexible Annuity (not a fixed income Annuity)
- Usually, if you withdraw your entire pension as a lump sum
Research by Retirement Advantage found that 43% of people who have made pension withdrawals felt it was nice to have a bit extra to spend, whilst 36% said they simply needed the money. Some reasons for making withdrawals included; to make home improvements (25%), to go on holiday (17%) or to buy a new car (12%). In the grand scheme of things, long-term retirement income no longer seems to be a priority, but it should be.
The problem is that as HMRC withdrawal figures show, over 55s are making multiple withdrawals in a tax year, using their pension like a bank account, for ad-hoc spending.
This can trigger the MPAA particularly early in life, often still during their career and potentially when employees are receiving ‘free money’ in the form of Automatic Enrolment employer contributions. If you do trigger the MPAA, there is no turning back, and other than relying on some particularly complex rules to potentially exceed the cap, future pension planning will be severely limited.
Avoiding the MPAA
There are two ways to make pension withdrawals without triggering the MPAA:
- Take tax-free cash and no income
You can take your 25% tax-free cash entitlement and enter Flexi-Access Drawdown and not trigger the MPAA as long as you don’t take any further income. The minute you do, the MPAA will apply and your pension provider is obliged to formally inform you within 31 days of the trigger date.
- Withdraw ‘small pots’
This is potentially the greatest planning opportunity of the two. The ‘small pot’ rule says that up to three pension funds worth £10,000 or less each can be encashed entirely, without triggering the MPAA. This is because the withdrawal does not count as a form of flexible access.
This option is particularly beneficial if an individual is nearing the Lifetime Allowance (LTA); the maximum you are able to tax-efficiently save in pensions over their lifetime, currently £1.03 million.
A small pot withdrawal would not trigger a test against the LTA (and hence a possible tax liability), where a flexible pension withdrawal would. It’s worth noting that for a small pot withdrawal to be an authorised payment, the pension holder must have some available LTA when the payment is made.
Logistically, if you have many small pensions it may mean some consolidation will be required to take maximum advantage of the rules. Similarly, where you have a pension value above £10,000 it may be necessary to subdivide the fund into existing smaller schemes or set up new arrangements. Effectively, you can manipulate your pension values to make maximum use of the total £30,000 small pot limit.
By not triggering the heavily restricted MPAA individuals can continue to save a meaningful pension contribution, up to the £40,000 Annual Allowance, or beyond if Carry Forward is available, but that’s a different story!
It’s quite complex, but an entirely feasible, tax-efficient planning opportunity. If you or one of your clients could benefit, and we strongly suspect many will, get in touch with one of the Sovereign team.