Hundreds of thousands of savers have dipped into their pension savings during the coronavirus pandemic, which may have triggered a tax charge that could make it a struggle to replace what has been taken.
Once you begin making pension withdrawals, you may be subject to the money purchase annual allowance (MPAA). In 2020-21 this reduces the amount that can be contributed to a defined contribution (DC) pension and benefit from tax relief, from £40,000 to £4,000.
Worryingly, eight in 10 people aged between 55 and 64 were unaware that their future pension contributions will be capped after making a withdrawal, according to a survey by financial advisory firm NFU Mutual.
Here, Which? explains how the MPAA works in more detail and looks at whether you should withdraw from your pot before you retire.
How does the MPAA work?
The government spends billions of pounds each year on pensions tax relief so it sets limits on the amount you can save.
Before you start to take money from your pension, you can earn up to £40,000 (or 100% of your income if you earn less than this), and still get a government top-up between 20% (basic-rate taxpayers) and 45% (additional rate taxpayers) on your contributions. This is your ‘annual allowance’.
If you’ve taken money out of your pension, you can still make contributions to a pension and earn tax relief. But you get a lower annual allowance if you want to make further contributions. For 2020-21 you can receive tax relief on contributions of up to 100% of your earnings or £4,000, whichever is lower.
If you exceed your allowance you will normally face a tax charge. The charge is broadly equivalent to the amount of tax relief you would have benefited from. The charge is declared to HMRC either through the income tax self-assessment process or by writing to them.
When is the MPAA triggered?
The MPAA is only triggered when:
- You take a lump sum from your pension called an ‘uncrystallised pension lump sum’ – you can take up to 25% of a DC pension tax-free once you pass the age of 55;
- You start taking an income from your pension through income drawdown – taking money out of your pension to live on in retirement once you pass the age of 55.
To retain the full £40,000 annual allowance you can take a 25% tax-free lump sum and buy an annuity or start a drawdown plan without taking an income.
If you’ve triggered the MPAA it can’t be undone. You also can’t carry forward any unused allowances from previous years to boost the amount you can pay into your pension.
If you’ve gone over the allowance, you may want to stop future contributions before 6 April 2021.
Why has the government set the MPAA at its current level?
The MPAA was introduced by the Treasury to stop people from recycling large sums of money through pensions to benefit from the extra tax-free cash.
The allowance was cut in the 2017-18 tax year, from £10,000 because the government believed that an MPAA of £4,000 is fair and should allow individuals who need to access to their pension savings to rebuild them if they subsequently have opportunity to do so.
However, while the average amount an individual withdrew from their pension has fallen from £14,444 between July and September 2015 to £6,714 over the same period in 2020, this could still take a pension saver a while to replace.
The coronavirus effect
The latest HMRC figures show the number of individuals accessing their pensions has jumped during the coronavirus pandemic.
The Revenue said that the 2% rise in the number of people withdrawing from their pensions between July and September compared with the second quarter of 2020 was ‘contrary to seasonal patterns’ and ‘may be attributable to the pandemic.’
Compared with the same quarter last year, there was a 6% increase in the number of people withdrawing from their pensions (347,000 compared with 327,000 in the three months to September in 2019).
Due to the pandemic, many people have lost their jobs, which means they could have been forced to access their pension.
Indeed, NFU Mutual’s research shows 20% of 55 to 64 year-olds are planning to take money out of their pension to make up for lost income as a result of the pandemic.
Wealth management firm Quilter has called on the government to relax the MPAA during the coronavirus pandemic. It wrote to chancellor Rishi Sunak in June recommending measures to protect people’s pots.
In order to prevent them suffering an unfair tax penalty when they go back to work, Quilter has called on the government to:
- waive the MPAA triggers for the 2020-21 tax year so people can retain the usual £40,000 annual allowance and
- restore the MPAA to £10,000 per year.
So far, the government hasn’t signalled any intention to adjust the rules.
Should I withdraw from my pot before I retire?
If you can’t afford to pay your day-to-day expenses your pension savings could help, but accessing them should only really be considered if you’ve exhausted all other avenues like your general savings.
NFU Mutual’s research shows that 32% of people over 55 who are still working plan to dip into their pot before they retire.
But you need to think carefully if this strategy suits your personal circumstances and make sure you leave enough for when you stop working to last you your entire life.
Where can I get help with my pension planning?
Pension planning can seem quite daunting at first, but it’s important to be ahead of the game and make the necessary arrangements for your future so you can enjoy a comfortable retirement.
Which? has analysed how much you’ll need in retirement, depending on whether you’re single or in a couple at the point you retire, and the kind of lifestyle you want. We’ve also got separate guides which can help you plan for retirement and cash in your pensions.