When pension inputs might be restricted
The financial services profession, like many others, is seriously infected with acronyms and abbreviations. We have things like MVR, which is a Market Value Reduction (it used to be MVA, the A standing for Adjustment, until someone realised the adjustments were only ever downwards). There’s the very ugly UFPLS (Uncrystallised Funds Pension Lump Sum) which I’ll save for another day, and, the subject of this article, the MPAA, which stands for Money Purchase Annual Allowance.
Now, before I can tell you what that is we first need to look at the Annual Allowance. This defines the maximum you can save into a pension in a tax year and get tax relief. Actually, I should have said Pension Input Period (PIP, another one), which didn’t always have to be one year long and didn’t have to coincide with the tax year, but for a few years now all PIPs have been aligned with the tax year. The Annual Allowance is relevant to all types of pension; personal pensions – or Money Purchase, but also known as Defined Contribution (DC) – as well as final salary pensions (Defined Benefit, or DB). Okay, that’s enough, no more abbreviations! And even though final salary schemes are not money purchase pensions, the MPAA can have an impact in some circumstances, but if I’m to avoid writing a small book on the subject, I’ll stick to personal pensions.
So, as I said, the Annual Allowance defines how much you can pay into a pension each year. Putting it into plain-speak, you can pay in up to £3,600 or 100% of your income, whichever is the higher, to a ceiling of £40,000. That £40,000 figure is the Annual Allowance. Two examples: Joe’s salary is £30,000, he can therefore pay £30,000 into a pension. Ann’s self-employed profits are £100,000 – she can pay in a maximum of £40,000. As an aside, it is indicative of the way legislation constantly changes that whenever I make a statement such as this, I’m almost always obliged to add an ‘except’, an ‘unless’, or a ‘but not when’. There are circumstances when Ann could pay more than £40,000 or might be restricted to less, but you’ll forgive me for not going into any further detail now.
So that’s ‘putting in’, now we need to look at ‘taking out’. Using the new flexible pension freedoms you can withdraw however much you like from your pension, as long as you’ve reached your 55th birthday (except…). One quarter of your pension fund can be taken as a tax-free lump sum (unless…oh, forget it!), and anything else you withdraw is treated as income and taxed under income tax. Once you have done that, i.e. withdrawn some taxable income, you come under the MPAA rules. This brings the £40,000 ceiling on what you can pay in, down to £10,000 a year. At least it was £10,000. The last Budget proposed reducing the MPAA to £4,000, a reduction that was postponed because of the June General Election, but it is coming back – and it will apply retrospectively to 6th April 2017, so to all intents and purposes we are already in the £4,000 MPAA regime (unless the Chancellor has a change of heart in his Budget next month – which I doubt, to be honest). Just one more ‘except’ – if you’re still in the old-style Capped Drawdown and don’t exceed the income limits then you are not affected by the MPAA. It only applies when the new flexible options are used.
You might be thinking that if you’re at the stage of withdrawing money from your pension fund, why would you be worried about paying back in? Well, there are plenty of scenarios. Imagine this: having decided to use the 25% lump sum to pay off her mortgage, Jenny found her tax free cash entitlement was a little short of her target, so she topped it up with a small amount of taxable income thinking she would be able to restore the pension pot with further contributions. But having had some income from the pension she is now, and forever more will be, restricted to £4,000 a year. Or this: Harry has taken some income from his pension, but then gets divorced. As part of the settlement his ex-wife gets half his pension fund. Harry now faces serious restrictions on his ability to rebuild his retirement savings.
The problem with the MPAA is that it is a sledge-hammer to crack a nut. It is supposed to discourage higher rate taxpayers from taking advantage of the pension freedoms to reduce their tax bill; taking money out, putting it back to increase their basic rate tax band, taking some out, putting it back, and round and round we go. But the reality is that the loss to the Exchequer is trivial in the grand scheme of things, and many are likely to be unwittingly caught out by this, especially if UFPLS (sorry, can’t avoid it) has been used, since any UFPLS withdrawal is automatically three-quarters income.
So the moral of this story, as always, is: seek advice before taking money out of your pension, or PPPPPP – Proper Pension Planning Prevents Painful Problems.
Philip Chandler APFS, CFPTM, Chartered MCSI
Chair of Aspinalls Technical and Investment Committee