Millions fall foul of pensions contributions rule

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Part-time work could boost your pension contributions tax bill

The money purchase annual allowance has had some unintended consequences

Almost a million savers could face punitive tax charges on their pension contributions because they have unwittingly triggered a substantial reduction in their annual contributions allowance. Between April 2015 and September 2018, 980,000 people made flexible withdrawals from their pension fund, according to pension provider Just Group.

They may now fall foul of the money purchase annual allowance (MPAA). This rule reduces the normal £40,000 annual allowance on pension contributions by a factor of ten. If you go over £4,000, you are taxed at your highest rate of income tax on the excess.

The MPAA was introduced alongside the pension freedom reforms of April 2015 to prevent people making withdrawals from their savings only to immediately reinvest this money to claim extra tax relief. However, it is now catching people out in ways policymakers didn’t anticipate. Some people, for example, have taken advantage of the pension freedoms to move into part-time work, making withdrawals from their pension savings to maintain their income but continuing to contribute.

People with irregular earnings, including the self-employed and directors, have also dipped into pension funds in order to smooth out their income, but have every intention of continuing to save. Even those taking an income but not expecting to make further contributions may change their mind if their circumstances change – because they receive a pay rise, say.

When does it apply?

The MPAA applies to the total pension contribution made across all money-purchase pension schemes (defined- benefit plans do not count) whether by you, your employer or a third party. The reduced allowance doesn’t come into force if you simply take the 25% tax-free lump sum from your pension, but any subsequent withdrawals would be classed as a flexible payment and trigger the tighter limits.

The MPAA will also apply if you move your savings into a “flexi-access drawdown scheme” and begin taking an income, or if you just cash in your entire pension as a lump sum, though there is an exception for those cashing in small funds worth less than £10,000. Savers buying investment-linked annuities offering variable levels of income are also caught – but not those with conventional annuities with a guaranteed level of income for life.

Finally, note that savers affected by the MPAA don’t even have the option of using the carry-forward rules, which allow most people to mitigate their exposure to tax by bringing forward unused pension contribution allowances from the previous three years.