This content is for information and inspiration purposes only. It should not be taken as financial or investment advice. To receive personalised, regulated financial advice please consult us here at Elmfield Financial Planning in Padiham, Burnley, Lancashire.
Many people like the idea of drawing from their pension from the age of 55 (or 57 from 2028, when the rules change). Perhaps you envisage continuing to work – albeit with fewer hours – whilst supplementing your income using funds from your pension pot. This can work for some people, yet drawing early from your pension can lead people to fall into a common pension tax trap – known as the Money Purchase Annual Allowance (MPAA).
Below, our team outlines how the MPAA rules work and offers some insights into how you can navigate them with the help of a financial adviser. We hope you find this content useful. If you’d like to speak to an independent financial adviser then you can reach us via:
T: 01282 772938
What is the Money Purchase Annual Allowance?
In 2020-21, you are normally entitled to contribute up to 100% of your earnings into a pension per tax year – or up to £40,000 (whichever is lower), tax-free. The tax relief you receive on your contributions incentivises you to save for retirement via a pension, whilst this “annual allowance” is intended to stop wealthier people amassing disproportionate retirement fortunes.
Once you start drawing an income from your pension, however, the MPAA rules come into effect – restricting how much you can keep putting into your pension, tax-free. These rules came into force following the Pension Freedom reforms in 2015, and first reduced an annual allowance to £10,000 per year once triggered. Today, however, they limit you to contributing up to £4,000 per tax year into a defined contribution pension – i.e. a 90% reduction.
What triggers the MPAA rules
Without professional advice, it would be easy for many people to trigger the MPAA rules without intending to. Unfortunately, once they have been activated you cannot get your original £40,000 annual allowance back. Here are some common actions/scenarios which trigger MPAA rules:
- Taking out your entire pension pot – either in one go, or in multiple ad hoc withdrawals.
- Going into flexi-access drawdown and starting to take a pension income.
- Buying a flexible annuity.
- Exceeding the limits on a “capped drawdown” pension (no longer open to new savers).
Other activities do not necessarily trigger the MPAA rules, although it would be wise to seek financial advice beforehand (just in case). In particular, withdrawing up to 25% of your tax-free entitlement as a lump sum is usually safe, as is using your pension pot to buy a lifetime annuity. You are also allowed to cash in a small pension pot containing less than £10,000.
Navigating the MPAA rules
Suppose you trigger the MPAA rules (e.g. after taking too much out of your pension as a lump sum). What does this mean for your finances? In short, it leads to a tax charge on contributions into your pension over £4,000 per year – rather than the previous limit of £40,000. Imagine you contributed £20,000 per year into your pension leading up to triggering the MPAA rules. As a Higher Rate taxpayer, not only would these contributions be free from tax, but you would also receive 40% relief – significantly boosting the growth potential of your savings. However, after the MPAA rules are triggered, you can now only save up to £4,000 in this fashion. If you keep putting in £20,000 per year, then £16,000 will be subject to 40% tax (i.e. £6,400).
Given the financial restrictions entailed by the MPAA rules, it is important to plan carefully prior to making any big decisions regarding your pension. For instance, if you are looking to reduce your working hours but maintain your level of income, it may be better to look to other income-producing assets you hold – rather than a pension. ISA savings, for instance, can be accessed from any age and this does not affect your annual allowances. You could consider property as a potential income-generating asset (e.g. rental income from a Buy To Let). Another option could be to downsize, pay off your mortgage and thus reduce your monthly outgoings – lowering the need to maintain your previous level of income as you cut back on hours.
For those with final salary pensions (or defined benefit pensions), it’s worth noting that the MPAA rules are not triggered when you start accessing income from your scheme. However, you will need to check the age from which your scheme will allow you to start taking income, as this is unlikely to be available from age 55. The administrators, however, may be willing to let you start taking benefits early in exchange for a lower annual income. In which case, it could be possible for someone with one (or more) defined contribution pension, a final salary pension and ISA savings to use the latter two strategically to start reducing work hours – whilst keeping a steady monthly income and avoiding triggering MPAA rules.
Invitation
If you are interested in starting a conversation about your own financial plan or investments, then we’d love to hear from you. Please contact us to arrange a free, no-commitment consultation with a member of our team here at Elmfield Financial Planning in Padiham, Burnley, Lancashire.
Reach us via:
T: 01282 772938
