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Why taking money from your pension could hit you with extra tax

What is the new money purchase annual allowance - and why does it matter?

The amount you can save into a pension once you’ve started taking money from is being slashed to just £4,000 a year, in a move that could cost savers £3,600 in lost tax relief.

Normally people are allowed to save up to 100% of their income for the year, capped at £40,000, into their pension and get full tax-relief on their contributions.

But once you’ve started taking money from your pension, a lower limit applies, designed to stop people from taking money out of their pension and putting it straight back in again, effectively claiming tax relief twice.

At last year’s budget, the Chancellor announced this limit, known as the money purchase annual allowance (or MPAA) would fall from £10,000 to £4,000 in April 2017. This limit includes tax relief and employers’ contributions.

When the snap election was called it looked like this change would be postponed. The government has now announced that the change will still go ahead – and it will apply retrospectively – which could be bad news for people who’ve already put more than £4,000 into their pension since April.

Who will be affected by the MPAA cut?

The most likely to be hit are those who are still in work but have decided to dip into their pension to cover unexpected bills at an earlier age.

An investigation published last week by the Financial Conduct Authority found that accessing pensions early has become ‘the new norm’. Almost three quarters (72%) of pension pots have been accessed by people aged under 65, most of whom have taken lump sums, since the pension freedoms were launched in 2015.

Doing so, however, could severely diminish you’re ability to build up a bigger pension in the run up to retirement, perhaps when you are reaching your earnings peak.

The MPAA limit only applies to people who’ve taken advantage of the new flexible access rules.

This could happen by taking income from your pension through a drawdown plan beyond your 25% tax-free lump sum. Or you could trigger the MPAA by withdrawing an ‘uncrystallised pension fund lump sum’, where the first 25% is tax-free and the remainder is subject to income tax.

But if you’ve only taken your 25% tax-free lump sum from your pension and nothing else, you won’t be affected by the MPAA, and will still be able to contribute a maximum of £40,000 a year to your pension. Other exceptions include:

  • Taking money from an existing capped drawdown arrangement (normally if you started taking money out of a pension before April 2015)
  • Taking your tax-free lump sum and buying an annuity with the remainder of your pension
  • Fully cashing in a pension worth less than £10,000
  • Taking an income from a defined benefit scheme

People who were deliberately ‘recycling’ money by taking money out of their pension and immediately putting it back in again to get two rounds of tax relief will also be hit.

How much could be lost by the cut to the MPAA?

If you’re in the affected camp and were planning to top up your pension by £10,000, you’re now only allowed to add £4,000. You’ll effectively lose tax relief on £6,000 contributions. What that’s worth depends on your tax rate.

Basic-rate taxpayers get 25p relief for every pound of taxed income they add to their pension – while people who earn more than £45,000 will get more.

The chart shows how much tax relief you’ll miss out on under the change.

What if I’ve already added more than £4,000 to my pension?

If you’ve already accessed your pension flexibly, you won’t get any tax relief on contributions above £4,000.

You’ll probably also get hit with a tax-charge, equivalent to the highest rate of tax you pay, for exceeding your allowance.

Can I save more by using carry forward allowances?

Normally, you can boost your retirement savings over the £40,000 allowance if you haven’t maxed out your pensions contributions in the last three years.

That’s not the case if you fall foul of the MPAA – there’s a strict £4,000 cap once you’ve started to draw money from your pension.

Find out more about carrying forward unused annual allowances.

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