Beware The Tax Trap On Pension Freedom Top-ups

Pension freedoms are now well established, with 300,000 lump sum payments and one million drawdown payments made in the first year alone.

However it appears that the Treasury’s approach to the reforms is still in transition, having just announced proposals that will more than halve the tax relief on pension top-ups for those who have drawn a retirement income.

The move highlights the minefield that still exists in retirement planning three years after the reforms were unveiled. So much has changed in recent times, and so much more is still to be properly understood, that it’s clear anyone acting alone and without adequate advice is vulnerable to a nasty surprise.

These latest developments concerning the Money Purchase Annual Allowance (MPAA) are significant for the many people who have already capitalised on the flexibility offered by pension freedoms, or are planning to do so.

Changes in the way we are choosing to take retirement means the MPAA will have an impact on those over 55s who are staying in work and who may want to put funds back into their pension where the opportunity allows.

Others with changed circumstances may suddenly find they need to rebuild their pension savings. MPAA will be an issue under both these scenarios.

However the Government is keen to address concerns about the potential for recycling, where people are able to achieve double tax relief by withdrawing money from their pension and then re-investing it.

What is MPAA?

MPAA applies if you have taken flexible benefits, which include income, such as an Uncrystallised Funds Pension Lump Sum or flexible drawdown with income, and you want to continue paying contributions to a Defined Contribution (DC) pension scheme.

Tax-free contributions to a pension scheme are currently subject to an annual allowance, which is normally £40,000. Anyone who exceeds this in a tax year will pay the excess amount at their marginal rate.

However, once you have flexibly accessed your pension you are subject to MPAA, which is currently £10,000 for all subsequent contributions to a DC pension.

This means an individual still in work can invest up to £10,000 of their earnings, tax-free, into a pension whilst also drawing out their DC pension savings. Acting in this way reduces an individual’s tax bill by 25% and, at the level of £10,000, this means £1,125 for an additional rate taxpayer.

However, MPAA is not triggered if you take a tax-free lump sum from your pension or if you’ve received up to £10,000 under small pots rules.

What’s changing?

Chancellor Philip Hammond is running a consultation until February 2017 that will look into whether to cut the level of MPAA from £10,000 to £4,000.

The Treasury says only 3% of individuals aged 55 and over make DC contributions of more than £4,000 a year to money purchase pension arrangements, with not all of these in drawdown.

It adds that the current MPAA of £10,000 is more than three times median DC contributions made by men aged 55 and over and five times those for women in the same age group.

The Treasury argues that anyone who uses a combination of MPAA and their ISA allowance has such a level of disposable income that their predicament is not in itself a justification for not closing the door to tax recycling.

What can savers do?

One tax-efficient alternative for those wishing to re-build their savings beyond the £4,000 limit is to consider the use of your ISA allowance, not only this financial year, but next year's too, when the current allowance of £15,240 is due to increase to £20,000 in April 2017.

In an ideal world, ISAs and pensions should already be working hand-in-hand in order to achieve the goal of a tax-efficient income in retirement.

That should be a conversation that over 55s are already having on a regular basis with their Bellpenny Financial Planner. Indeed, it may be better to avoid touching the pension savings in the first place and looking at other available assets.

With MPAA, any change in the limit is not due to come into force until April 2017. So this means there’s an opportunity for savers to bring forward some of their allowance into this tax year, when the limit will still be £10,000.

It’s worth remembering that you cannot bring forward any unused allowances from previous tax years.

Overall, the MPAA issue shows there’s much still to consider in relation to the new pensions regime, particularly among those for whom the process of going into retirement is no longer the sudden occurrence it was many years ago.

With the rules and regulations having shifted considerably, it could be a potentially costly mistake to be caught out by this latest change.