Pension Clinic: beware the £4,000 pension contribution trap

Many people have been caught out by changes to the rules around paying more into your pension after you have started taking money out.

Once upon a time, the government decided it wanted to simplify the rules around pensions and tax. There were going to be simple annual and lifetime limits on pension tax relief, and lots of the old complexity was going to be swept away. This was in 2006.

But since then, far from leaving things alone, successive governments have tweaked and fiddled with the rules, which mean that it can be a nightmare for law-abiding citizens even to understand what they can and cannot do.

One of the worst examples of this complexity is the recent changes to the rules around the amount of money you can pay into a pension with the benefit of tax relief, when you have already started taking money out of a pension.

In this month’s Pension Clinic, I will try to help readers to navigate this complexity – and potentially avoid a fine for not complying with the law.

Changed world

When many pension rules were first designed, the world was largely divided into two separate groups of people – those putting money into a pension and those taking money out of a pension. But the radical ‘pension freedoms’ reforms of 2015 changed all that.

Under these changes it became far easier for people to take money out of their pensions – perhaps to meet a short-term spending priority – and then later on (or even at the same time) to start putting money back into pensions.

From the government’s point of view, however, this created a potential loophole. Because 25% of any pension pot can be taken tax-free, there was a risk of people taking their money out of a pension, thereby benefiting from a tax-free lump sum, and then putting it all back in with the benefit of a tax relief top-up on the whole amount. In theory, they could do this over and over again, benefiting each time from more and more tax-free cash.

In order to limit the potential for this, in 2015 the government created something called the money purchase annual allowance (MPAA). Originally set at £10,000 per year and now reduced to £4,000 per year, this is a heavily reduced limit on the amount of money you can put into a ‘pot of money’ pension each tax year whilst benefiting from tax relief, and is triggered when you first take taxable cash out of a ‘pot of money’ pension.

This means it is not triggered in a number of circumstances:

• if your only pension income is from a salary-related pension;
• if you only take your tax-free cash and leave the rest in a flexible drawdown account which you do not touch;
• if the pension pot you cash out is worth less than £10,000.

Although this all sounds quite technical, I suspect that this complexity means that there may be many people who have inadvertently triggered the MPAA and are now wrongly claiming tax relief.

For example, consider the case of someone who has two pension pots from two different jobs. Suppose that they have accessed one of them in full, taking their tax-free cash and paying tax on the balance. This triggers the MPAA and means they can now contribute no more than £4,000 per year (including the value of any employer contribution) into a pot-of-money pension with the benefit of tax relief. If they are earning £45,000 per year and they and their employer between them are contributing 10% of pay to their pension, they will be paying in £4,500, which is over the MPAA. They will then face a tax charge to recover the tax relief on the final £500 of pension saving.

Onus on the saver

Amazingly, the onus is on the saver to notify the second pension scheme that they have triggered the MPAA. The first scheme is supposed to send a letter confirming that the MPAA has been triggered, and the saver then has three months to notify the second scheme – or else face a fine which starts at £300 and increases with every day of delay.

In an ideal world, we would be making it easier and simpler for people to save into pensions. But HMRC is so obsessed with the risk that a small minority might take advantage of potential loopholes that it has introduced greater complexity for everyone – and the MPAA is but the latest example of this.

Steve Webb is director of policy at Royal London.

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