When “pension freedoms” were introduced, many saw it as a great way to access their pension well before retirement age. But the tax incentives with pensions can often prove too valuable to give up, and hasty decisions risk leaving some people worse-off in the long run.
The Money Purchase Annual Allowance (MPAA) was introduced as part of a range of pension changes carried out by the government back in 2015. One of the changes that some have taken advantage of is the ability to take out up to 25% of your pension as a tax-free lump sum, with the remaining 75% still subject to tax. Back then, the rule changes were touted as being ‘pension freedoms’, although some of these freedoms do carry a bit of a sting in the tail.
Whenever you or your employer pays money into your pension, the government tops up your contribution with tax relief. For most people, the amount they can pay into their pension each tax year and get tax-relief on is limited to an annual contribution of £40,000. Also, when you make contributions to your pension, you benefit from being able to use the ‘carry forward’ rule, which means you can claim any tax relief you haven’t used for pension contributions made in the previous three tax years.
However, the government’s generosity when it comes to offering tax incentives while you accumulate your pension pot get swiftly taken away once you decide to access your pension. The MPAA is triggered once you’ve started to draw on the taxable part of your pension (this doesn’t include the tax-free lump sum you are entitled to) and from that point forward, the MPAA effectively limits the amount of tax relief you can receive on any future pension contributions.
Back in 2015, when the MPAA was first introduced, the annual contribution limit for those affected by the MPAA was set at £10,000, rather than the full £40,000 Annual Allowance. However, this limit has now shrunk significantly and, for the 2021/22 tax year, the MPAA is set at just £4,000. This means that if you’ve triggered the MPAA you can expect to pay tax on all future pension contributions above this amount, and the MPAA will be with you for life.
The MPAA only affects those with defined contribution (DC) pensions, and who have chosen to access their pension flexibly, including self-invested personal pensions (SIPP). Money purchase restrictions do not affect defined benefit (DB) pensions.
Should you start to make use of pension freedoms to flexibly access your pension, you will trigger the MPAA, which means you will only then be able to contribute up to £4,000 to all your DC pensions each year. Also, you will not be able to make use of any unused pension contribution allowances (known as ‘carry forward’) from previous tax years.
We have heard examples of people who have taken out their tax-free lump sum, and then topped up this amount by drawing down a smaller amount from their taxable pension. Unfortunately, this is just the type of activity where the MPAA rules are catching people out.
If you do happen to go over your annual contribution limits, then you should expect HMRC to catch up with you at some point. When they do, you will face a tax charge in line with the rate of tax you pay.
Here’s a quick example of what can easily lead someone into falling foul of the rules. Victoria has £100,000 invested in her personal pension, and is also still a member of her employer’s pension scheme. Victoria would like to build a new conservatory, which costs £25,000, and would also like to draw down an extra £5,000 for a holiday. She instructs her pension provider to drawdown £30,000, knowing that she will pay tax on the £5,000 above the tax-free lump sum (25% of the pension) available.
Unfortunately, once Victoria takes out the £30,000, she has triggered the MPAA, because she has withdrawn more than the 25% tax-free element of her personal pension and is deemed by HMRC to have ‘flexibly accessed her pension’. Had Victoria chosen to get financial advice before contacting her SIPP provider, she would have been made aware of the dangers of triggering the MPAA and revised her plans accordingly. Instead, from now on, Victoria will only be able to contribute an annual maximum of £4,000 across all her pensions, which could well prove costly as any contributions above this level will attract a tax charge.
It’s definitely worth remembering that you won’t trigger the MPAA if you only withdraw from your pension an amount that doesn’t exceed your 25% tax-free lump entitlement. You also will not trigger the MPAA if you use your pension to purchase a lifetime annuity, or if the cash accumulated in your pension pot is valued at less than £10,000.
If anyone is considering accessing their pension, and taking advantage of ‘pension freedoms’, we suggest you talk to us first. We can help you to work out the most tax-efficient way of accessing your pension, without making any costly mistakes that could leave you worse off in the future.
If you are interested in discussing your current pension arrangements with one of our experienced financial planners, please get in touch here.
This content is for information purposes only. It does not constitute investment advice or financial advice.
