Why contributing to your pension could cost you if you’re already taking benefits

Published on June 6, 2019 by Andrew

If you’re over the age of 55 and already drawing some benefits from your pension, there’s a chance you could be paying unnecessary tax on your contributions.

In the last couple of years, the government has reduced the Money Purchase Annual Allowance (MPAA) – the amount you can contribute to your defined contribution while still benefiting from tax relief.

But what is the MPAA? When does it apply? And what happens if your pension contributions exceed the MPAA?

What is the Money Purchase Annual Allowance (MPAA)?

Your annual allowance is the amount that you can contribute to your pension each year while still receiving tax relief. It is based on your earnings and there is currently a cap of £40,000.

A lower limit of £4,000 applies if you’ve already started accessing your pension benefits, and this lower limit is the MPAA. The allowance includes both your own and any employer contributions.

How much is the MPAA?

The MPAA was introduced on 6 April 2015 and was set at £10,000.

The government reduced the MPAA to £4,000 in April 2017, with the legislation coming into force in late 2017.

Why is there a limit? Why does the MPAA exist?

The aim of the MPAA is to stop individuals from using pension freedoms as a way to avoid tax on other earnings.

Without the limit, you could withdraw 25% of your pension fund tax-free, and then reinvest it in your pension and gain tax relief on your contribution. The aim of the cap is to stop people generating a second amount of tax relief on pension contributions – a process often called ‘recycling’.

As it is now more common for pension contributions to continue after crystallisation – partly due to more people taking a phased retirement – the ability to continue to make contributions is important.

By establishing a limit of £4,000 rather than banning additional contributions altogether, the government acknowledges that individuals should be allowed to both access their pension savings and to rebuild them if they want to do so.

A downside may be that you could be accessing your pension benefits flexibly but also belong to a pension scheme into which your employer pays more than the £4,000 annual allowance through the auto-enrolment initiative.

The MPAA applies each tax year, and you can’t bring forward any unused allowance from a previous tax year.

When does the MPAA apply?

For the MPAA to apply, you must have started taking money from your pension as a flexible income from the age of 55 onwards. The MPAA applies when:

  • You have withdrawn more than the 25% tax-free pension commencement lump sum
  • You have moved your pension into Flexi-Access Drawdown and you have started drawing an income
  • You have bought an Annuity with flexible benefits
  • You have exceeded the withdrawal limit for a Capped Drawdown plan

If any of these events occur, the reduced MPAA will normally be triggered immediately. That means if you take just £1 more than you should from your pension benefits, you could immediately restrict further contributions.

Note that the MPAA only applies to money purchase contributions. So, you can still contribute to a defined benefit scheme up to the current annual allowance of £40,000, less any contributions up to the MPAA you make to a defined contribution scheme.

So, if you make contributions of £4,000 to a defined contribution scheme, you’ll be able to pay up to £36,000 into a defined benefits scheme.

When will the MPAA not apply?

You will normally avoid triggering the MPAA if you:

  • Take any benefits non-flexibly (for example, you purchase a non-flexible Annuity)
  • Withdraw a lump sum below your 25% entitlement
  • Cash in a small pension fund value at under £10,000. While you can take 25% tax-free and the remaining 75% is taxed at your marginal rate, it does not trigger the MPAA
  • Receive pension benefits from a ‘defined benefit’ scheme
  • Vest your pension balance to drawdown, but don’t take income

What happens if I exceed the MPAA?

If you exceed the MPAA you’ll face a tax charge at your marginal rate of income tax. Remember that, unlike normal pension contributions, if you’re subject to the MPAA then you can’t carry forward unused allowances from the previous three tax years.

If you’re not subject to the MPAA then the annual contribution limit of £40,000 will continue to apply, and you can carry forward unused allowances.

If you’re unsure whether you’re subject to MPAA restrictions, we can help. As pension specialists, we can help you ensure that you can drawdown the income you need and maintain annual contributions. Please get in touch by email at info@thepensionplanner.co.uk or call 0800 0787 182.

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. Levels, bases of and reliefs from taxation may be subject to change and their value depends on the individual circumstances of the investor.

This newsletter does not represent a personal recommendation and you should seek independent financial advice.

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