Did you know that usually, you can contribute up to 100% of your annual salary (or up to £40,000 – whichever is lower) towards a pension every year without incurring tax?
This is known as your “Annual allowance”, and everyone is entitled to one. Some higher earners are rightly aware that this allowance is reduced by £1 for every £2 of adjusted income they earn over £150,000. What many people are not aware of, however, is the “money purchase trap”.
Indeed, it is possible to be very clued up about pensions yourself but to have never heard of this trap. Yet it can be a big problem, possibly affecting as many as one million Britons.
The money purchase trap relates to an obscure rule in the world of pensions, called the Money Purchase Annual Allowance (MPAA). Essentially, the MPAA reduces how much money you are allowed to take out of your pension pot, tax-free, whilst continuing to contribute to it.
In 2019-20 this reduced cap is set at £4,000, which is quite a big step down from the normal £40,000 annual allowance! Unfortunately, many people are unwittingly being penalised by this rule without realising it because they are using their pension pot a bit like a bank account – putting money in and taking money out when they need it.
Here at WMM, we want to help you avoid this kind of costly mistake by being aware of the issue, and some of the common pitfalls which people fall into. As always, the best course of action is to consult with an independent financial adviser to devise a strong, well-thought-through financial plan which side-steps the MPAA trap and others like it.
This content is for information purposes only, and should not be read as financial advice. To receive financial advice into your own specific needs and circumstances, speak with a financial planner to ensure you make the most informed decision about your finances.
What sets off the MPAA trap?
The MPAA trap generally starts to become an issue if you take more than your 25% tax-free lump sum from your pension pot. Under the 2015 Pension Freedoms, this is an option to people with defined contribution pensions after the age of 55.
So, if you are approaching retirement and are considering taking more money out of your pension pot than 25% of its value, you need to carefully consider the effect this has on your annual allowance. After all, doing so would reduce your allowance from £40,000 (assuming you are entitled to this amount) to one-tenth of that (£4,000).
If you think there’s a chance that you might continue saving for retirement after the age of 55, then you need to factor this MPAA trap into your financial plan. It might be tempting to want to take 30% or 40% out of your pension pot, to pay for a house extension or help your children onto the property ladder. However, these decisions would take you over your 25% tax-free cap, and so should not be taken lightly without seeking independent financial advice.
There are other scenarios which you should be aware of, which can also fire the “MPAA trap”:
- Taking spontaneous lump sums thoughtlessly from your pension.
- If you buy an annuity which is “investment linked” or “flexible”.
- If you commit your pension pot to a flexi-access drawdown plan and start taking money from it in order to provide an income.
- If you have a “capped drawdown” plan prior to 2015, and the payments you take start to go over the cap.
How do I avoid the MPAA trap?
The first step is to plan very carefully with a professional who can help you navigate this kind of complex tax landscape. After all, lots of rule like this exist in the world of pensions and it’s easy to unwittingly fall into a pothole if you don’t completely know what you’re doing. A financial planner will be able to help you plan properly ahead, see the bigger picture and make more intelligent financial decisions based on facts, rather than emotion.
As a general rule, to try and avoid the MPAA trap it is usually a good idea to avoid taking flexible income unless you absolutely need to take it. Be careful not to simply, carelessly splash money from your pension pot onto an expensive holiday, property or possession.
For some people (not all), the best option for their retirement income is to buy a strong lifetime annuity product, which provides a steady or increasing income. If so, then this option usually sidesteps the MPAA trap quite nicely.
Alternatively, you could take your tax-free lump sum and commit the rest of your pension money to a flexi-access plan, but not take any income from it until you properly retire. In the meantime, you can continue to build up your pension pot whilst you keep on earning, and possibly later on in your life you can buy an annuity (if appropriate) or start withdrawing from the pot to help with your retirement income.
In all cases, the important thing is to plan carefully and to look at the long-term impact your decisions will make on your finances and retirement income.
It is worth stating that if you now find yourself in the MPAA trap, then there are still some options open to you. The first important thing to say is to consider your ISA allowance, which in 2019-20 allows you to save up to £20,000 per year without being taxed.
Other ideas could be to look at investing into Venture Capital Trusts (VCTs), which offer a tax-efficient way to invest in businesses. Be aware, however, that this route is usually higher-risk than committing your money to a cash ISA, for instance, and you should seek the advice of an independent financial adviser before committing big sums to these sorts of options.
