Pension Clinic: take cash early and you may face a cap on future contributions, warns former pensions minister.
Since the pension freedoms introduced in April 2015, everyone has a range of options as to how to access their pension. These include taking the whole lot out (subject to a potentially large tax bill) or leaving the whole lot in and then taking chunks as and when required. However, although these reforms are described as giving savers ‘pension freedom’, that freedom is not unrestricted.
HMRC simply couldn’t get away from its old assumption that people are always out to ‘game’ the system. As a result, a brand new limit was created to make sure people did not recycle money through their pensions, exploiting the freedoms by taking tax-free cash every time they made withdrawals and then reinvesting it with further tax relief.
New MPAA limit
The new limit is called the Money Purchase Annual Allowance (MPAA), and it is one that anyone thinking of taking money out of a ‘pot of money’ pension should be aware of.
When the MPAA was first introduced it was set at £10,000 per year, but in 2017 it was cut to just £4,000. With limited exceptions, anyone who takes taxable cash out of a ‘pot of money’ pension is only allowed to put £4,000 per year into such pensions in future, if they want to enjoy tax relief on those contributions. This compares with the standard annual allowance of £40,000.
How does it work? Suppose you have a pension pot of £20,000, take a tax-free lump sum of £5,000 when you reach age 55, and leave the balance of £15,000 in a drawdown account.
Up to this point you have not taken any taxable cash, so the MPAA does not apply. But suppose that you now lose your job and need some cash. As soon as you touch any of the £15,000 you trigger the MPAA and are now limited to annual contributions capped at £4,000 per year into ‘pot of money’ pensions.
Suppose you now get a new job with a good workplace pension. Let us assume you earn £30,000 and you and your employer together contribute 15% of your pay into your pension – an annual contribution of £4,500. Unfortunately this is in excess of the MPAA. Either you reduce the total pension contribution to stay within the limit, or you pay a tax bill on the final £500 above the limit; in either case, the fact that you have taken taxable cash limits your ability to build up a pension in future.
The MPAA: need-to-knows
The MPAA is not triggered by taking money out of a salary-related or defined benefit pension, only by taking taxable cash from a ‘pot of money’ or defined contribution pension.
As soon as you take taxable cash from one pension (perhaps an old pension from a previous job) you have a legal duty to notify any pension scheme of which you are an active member that you are affected by the MPAA.
You should get a letter from the first pension scheme telling you that you need to do this, but if you fail to act on it you can face a fine from HMRC. Amazingly, when I asked HMRC via a Freedom of Information request how many people had been fined since the new rules came in, they were unable to tell me. But if you fail to notify within three months of triggering the MPAA, you face both a one-off fine and an additional fine for each extra day that you delay, so this is one letter from your pension provider you don’t want to ignore.
One exception to the rule is if you take money out of a ‘trivial’ or small pension pot. If you empty a pension worth under £10,000 this generally does not trigger the MPAA, so your future ability to build up a pension is not restricted. It follows that if you require a relatively small sum from your pensions, it could make more sense to empty a small pot rather than make a partial withdrawal from a large pot, as the former approach will not trigger the MPAA.
Steve Webb is director of policy at Royal London.