A quarter of a million over 55s get caught out by this pension tax trap each year – don’t be one of them

The little-known Money Purchase Annual Allowance is catching out thousands of pension savers each year. Here are a few ways to prevent yourself from falling into the trap.

A little-known pensions rule catches out thousands of savers every year, and has potentially become more prevalent because of the pandemic, according to new data. Some 5,000 over 55s are stung every week by a little-known pensions rule called the Money Purchase Annual Allowance (MPAA), data from retirement firm Just Group has shown. The Money Purchase Annual Allowance (MPAA) is a specific rule which can be accidentally triggered by savers, cutting the amount they can save in to pensions tax-free under their annual allowance. The figures from Just Group suggest some 260,000 people are being caught out by the rule every year.

What is the Money Purchase Annual Allowance?

The Money Purchase Annual Allowance (MPAA) is a rule which defines how much you can deposit into a pension each year and still receive tax relief on those contributions. The normal limit is £40,000 and is defined by the amount you contribute into a Defined Contribution (DC) pension, including employer contributions. With Defined Benefit (DB) pensions – also known as final salary pensions – this is defined as the amount by which it increases in value each year. However, the MPAA – which is triggered by a particular set of circumstances – can cut an individual’s annual allowance from £40,000 to £4,000.

Those triggers include:

  • Taking an entire pension pot as a lump sum or starting to take ad-hoc lump sums from a pension pot
  • Putting pension pot money into a flexi-access drawdown scheme and taking an income
  • Buying an investment-linked or flexible annuity where income could drop
  • Having a pre-April 2015 capped drawdown plan and taking payments that exceed the cap

The rule is in place so that no one can benefit from having a pension income while still feeding new cash into a pension pot and taking the benefit of tax relief. While the rule is a feature of the system rather than a failure, the contention is that some over 55s who may not have otherwise triggered the MPAA during normal times, have been inadvertently hit by it during the coronavirus crisis. For instance – someone aged 55 may have been in full-time employment and still contributing to their pension regularly, with no intention of drawing money out of the pension because they still had a salary. Thanks to the economic crisis caused by the pandemic, they may have since needed to access extra cash as an emergency, or even lost their employment, and with it, regular pension contributions.

Even if the MPAA is triggered under these circumstances the person is treated as if they’re now living on their pension income. They are then unable to return to making regular contributions up to £40,000, even if they don’t intend on using their pension for an income and still want to put more in.

What is the best way to avoid MPAA?

The good news is, there are some steps you can take to avoid being penalised inadvertently.

  1. Have a rainy day fund. Many people have been forced to trigger the allowance because they’ve needed short-term cash during a crisis. Having a solid rainy-day fund in cash savings would prevent this.
  2. Don’t take more than the 25% tax-free lump sum from your pension. You can take up to 25% from your pension tax-free, so if you don’t go over this, it won’t trigger the MPAA
  3. Take from smaller pension pots first. Any pension pot you have under £10,000 will be exempt from MPAA if you make a withdrawal. However, you can only do this in a maximum of three non-occupational pots.

Once you retire and begin to rely more on your pension the MPAA may become unavoidable. But if you’re no longer earning a salary or contributing new cash routinely to a pot, this shouldn’t be a huge issue. The trick is to be careful around the time when you are looking to use some pension funds if you are still earning from a salary and trying to save and benefit from tax relief.

If you’re interested in discussing the MPAA more, or want to know anything else about your pension, don’t hesitate to get in touch with your adviser.