Since the pension freedoms were introduced in 2015, this has given individuals much more flexibility over how they can take the benefits from their pensions. You can now take your benefits as and when you need them without restriction as long as you are over the age of 55 (57 from 2028).
There are many positives to this new flexibility, for example people that need to fund a large expenditure prior to their retirement could access some of their pension savings to finance this without having to take the entire pot in one go. However, there are some potential pitfalls when accessing benefits flexibly and it is important to be aware of these before taking any benefits so that you can assess whether these could cause you issues in the future.
The Money Purchase Annual Allowance (MPAA)
The MPAA was introduced to stop people accessing their benefits flexibly and then recycling the money back into the pension to benefit from tax relief more than once. The MPAA means that if you take a taxable income from your pension when using a flexible drawdown arrangement, your Annual Allowance (the maximum tax relievable amount that you can pay into a pension each year) will be reduced from £40,000 to just £4,000 in the current tax year and subsequent ones thereafter.
This could cause huge problems for someone that is still working and planning to further fund their pension but needs to access a one-off sum in the short term as it would hugely reduce their potential future contributions.
The key point here is that it is only when you take any taxable income via flexible drawdown that the MPAA comes into force. This means that you can access some or all of the tax-free Pension Commencement Lump Sum (PCLS) without the MPAA coming into play and your future pension funding potential would be unaffected. You could even elect to receive a regular income from the tax-free part of your pension and the MPAA would not apply.
An important feature of the MPAA is that it only applies to taxable benefits taken via flexi access drawdown. Those with a policy that is in “capped drawdown” from prior to April 2015 are able to take benefits from both the tax-free and taxable element of their pension without triggering the MPAA.
Capped drawdown allowed individuals to take drawdown benefits from their pension but it was subject to an annual limit calculated from a set of tables produced for HMRC by the Government Actuaries Department (GAD) (known as the GAD limits). Although capped drawdown was replaced by flexi access in drawdown in 2015, existing plans are able to remain in capped drawdown as long as benefits taken remain within the GAD limits. As long as this remains the case, the MPAA will not come into play. A capped drawdown plan can be converted into a flexible access drawdown plan at any time if you need to take benefits in excess of the GAD limits. However, this option should be given plenty of consideration as the MPAA will apply from the point that any flexible income is taken from the plan after this conversion takes place.
The MPAA in practice
When the MPAA is triggered, there are two possible scenarios, the input into a defined contribution scheme is:
- Less than or equal to £4,000
- Greater than £4,000
Let’s assume that the MPAA is triggered early in the tax year so that all subsequent contributions occur after the trigger event.
- If the MPAA is triggered and subsequent money purchase contributions are equal to or less than £4,000, the member’s annual allowance is £40,000 (including any MPAA used) unless tapered annual allowance applies.
- It is possible to carry forward unused annual allowance from previous three tax years but only to be used towards contributions related to final salary schemes
Any unused MPAA cannot be carried forward to future years.
An individual takes flexi access income from his plan at the beginning of the tax year and has used up all of his Annual Allowance in previous tax years. He subsequently contributes £3,000 to his money purchase plan and has a deemed pension input of £33,500 into his employer’s final salary arrangement. As the inputs are after triggering the MPAA and his money purchase contributions are less than £4,000 there is no need to test against the MPAA and the total input is tested against the £40,000 Annual Allowance. The total is £36,500 so there is no tax charge.
What if the MPAA is triggered and subsequent money purchase contributions are in excess of £4,000?
As well as the Annual Allowance, a member who has flexibly accessed their plans also has an Alternative Annual Allowance which can only be used in respect of final salary or cash balance scheme contributions. The member therefore has a £4,000 Money Purchase Annual Allowance and a £36,000 Alternative Annual Allowance in addition (unless the high-income taper applies).
- It is possible to carry forward unused Annual Allowance from previous three tax years to increase the Alternative Annual Allowance
- You cannot use carry forward to increase the MPAA
- Any savings tested against the MPAA are not tested against the Alternative Annual Allowance
- Where the money purchase contributions exceed the MPAA, there will be an Annual Allowance tax charge to pay which will be the equivalent of the individual’s marginal rate of tax on any excess contributions
What if the MPAA is triggered later on in the tax year and contributions have been made both before and after the MPAA applies?
In these circumstances, the money purchase pension contributions are split into two parts:
- The contributions made before the trigger event
- The contributions made after the trigger event
- Any contributions made before the trigger evet are not tested against the MPAA
- Any contributions made after the trigger event are tested against the MPAA and any further payments made in future tax years will also be tested against the MPAA in that year
- Where the money purchase contributions made after the trigger event are in excess of the MPAA, the contributions made prior to the trigger event are tested against the Alternative Annual Allowance
- An individual has used up her Annual Allowance in the previous three tax years and is planning to begin taking benefits halfway through the tax year. As they are aware that the MPAA will be triggered at this point, they make contributions £40,000 to maximise their input prior to retirement. Later in the tax year, they trigger the MPAA but as the contributions were made prior to this, they are tested against the £40,000 Annual Allowance and there is no Annual Allowance tax charge. However, in subsequent years, the MPAA will apply for all contributions.
- An individual makes money purchase pension contributions of £600 per month into their Personal Pension. After having made contributions from April to October, they crystallise part of their plan, triggering the MPAA but continue to make their £600 p.m. contributions. This means that seven contributions were made before the trigger event (totalling £4,200) and five were made after the event (totalling £3,000). The contributions made before the trigger event are ignored when testing against the MPAA so only the contributions made afterwards of £3,000 are tested. As they are well within the £4,000 allowance, the MPAA is not breached and the total contributions of £7,200 are tested against the full £40,000 Annual Allowance so again there is no tax charge.