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Join Which? MoneyPension tax: could thousands of older workers get caught in a tax trap?
You may trigger the Money Purchase Annual Allowance if you've dipped into a
pension you still contribute to
An investment firm has warned that thousands of workers aged over 55 who pay into a pension could face an unexpected tax bill.
Once you've withdrawn money from your pension, your annual tax-free allowance will be reduced if you want to make further contributions. This is called the Money Purchase Annual Allowance (MPAA).
AJ Bell says it unfairly penalises people who may be forced to access taxable income from their pension during the cost of living crisis.
Here, Which? explains what the MPAA is, why there are calls for it to be increased, and how you can access your pension without triggering it.
What is the Money Purchase Annual Allowance?
The MPAA applies to people who have taken money from a money purchase, or defined contribution (DC) pension, and restricts how much tax relief you’ll earn saving into a pension.
Most people can contribute up to £40,000 to their DC pension during the tax year and receive tax relief on the full amount. This is the pensions annual allowance, and it includes contributions from your employer.
But if you trigger the MPAA, this reduces to £4,000 a year. Exceeding this amount means you could end up with a tax charge.
Triggering the MPAA also stops you from being able to carry forward any of your unused annual allowance from the three previous tax years, which you'd usually be allowed to do. You also cannot carry forward any unused MPAA.
When it was introduced in 2015, the MPAA was originally set at £10,000 a year – the limit you could get tax-free – but it was reduced to £4,000 in the 2017-18 tax year.
- Find out more: money purchase and DC pensions explained
What triggers the MPAA?
The MPAA is only triggered when you take a lump sum from your pension called an 'uncrystallised pension lump sum', where you haven't 'crystallised' your pension pot by turning it into an income, or you start taking an income through pension drawdown.
It only applies to contributions to defined contribution pensions and not defined benefit pension schemes.
To retain the full £40,000 tax-free annual allowance, you can take a 25% tax-free lump sum and buy for an annuity, or start a drawdown plan without taking an income.
Why could more workers trigger the MPAA?
In the first three months of the 2022-23 tax year, more than half a million people in the UK withdrew £3.6bn from their retirement pots, a 23% increase from the same period in 2021-22, according to government statistics.
Investment firm AJ Bell said that although we don’t know exactly why this much money was withdrawn, rising prices caused by spiralling inflation could well be the reason.
Tom Selby, head of retirement policy at AJ Bell, said: ‘With millions of families struggling to pay the bills at the moment, for many, turning to their hard-earned pensions will feel like the only option.
‘There will also inevitably be lots of parents or grandparents who are taking some income from their pensions to help younger generations get by.’
- Find out more: how much do you need to retire?
'A quarter of pensioners risk breaching the MPAA’
AJ Bell put these concerns in a letter to the Treasury last year, and said the Chancellor should increase the MPAA to £10,000 in the next Budget.
In response, Andrew Griffith, economic secretary to the Treasury, revealed that a quarter of pension savers over 55 had contributed more than £4,000 a year to their pensions in the 2020-21 tax year, which means some could have breached their MPAA.
However, Griffith did point out that this figure includes those who have not yet accessed their pensions flexibly, so not all of these pension savers may have triggered the MPAA.
As HMRC does not publish MPAA statistics independently, it’s difficult to know how many people may be breaching it.
- Find out more: 9 pensioner perks and benefits to boost your income
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Listen nowWill the MPAA be scrapped in the Budget?
Jeremy Hunt is facing calls to axe the MPAA in a bid to encourage older people to return to the workforce.
If the MPAA were to increase, or be removed altogether, some argue that it would encourage more people who have taken a career break to return to work, as they would have a better chance of rebuilding their pension.
There have also been calls to permanently axe the lifetime allowance. This is the limit on how much you can save into your pension pot before being hit with a tax charge. In 2022-23, the lifetime allowance remained at £1.073m and is currently frozen until 2026. It's been argued that its removal would provide another incentive for over-50s to return to work.
How to avoid triggering the MPAA
There are some ways you can avoid triggering the MPAA.
Take a 25% tax-free lump sum
You can take 25% of your pension as a tax-free lump sum. You're free to use this as you like – one option could be using it to buy a lifetime annuity, which provides a guaranteed income for life.
- Find out more: Should I take a lump sum from my pension?
Take a small pot withdrawal
If your fund is worth £10,000 or less, you should be able to withdraw both the tax-free and taxable element flexibly without triggering the MPAA. But you need to check with your provider that it will be treated as taken under the small pot lump sum rules. Otherwise, there’s a risk the MPAA will be triggered.
Note that you must extinguish the entire fund in order not to trigger the MPAA, and you can only take up to three small pot withdrawals worth £10,000 or less in your lifetime.
- Find out more: How to find your pension pots
Get pensions guidance and advice
You can get free, impartial guidance from the Money and Pensions Service. If you're over 50, you can book a free guidance session with a specialist.
It may also be worth paying for financial advice, as pensions and investments are complex – our guide on how to get retirement and pension advice explains how it works.
