Tempted to dip into pension savings before retirement? Beware the tax trap that could prevent you rebuilding your pot

Inflation has piled pressure on household budgets and rising interest rates have made mortgages more onerous, leading many older workers to look towards their private pension savings earlier than they might have planned. 

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Published: 06 Feb 2024 Updated: 06 Feb 2024

Reasons for savers to dip into their pension pot early have multiplied in the last few years.  

Inflation has piled pressure on household budgets and rising interest rates have made mortgages more onerous, leading many older workers to look towards their private pension savings earlier than they might have planned. 

The pandemic also prompted many older workers to reassess their priorities and the ‘Great Retirement’ left Britain with a quarter of a million more 55- to 64-year-olds who are economically inactive – neither in work nor looking for work.  

From 2019 to 2022 the employment rate of older adults decreased each year from a record high in 2019 of 72.5% to 70.7% last year – but it is starting to tick up again.[1] 

Gary Smith, Financial Planning Partner and retirement specialist at wealth manager Evelyn Partners, says: “We see some early retirees, after a few years of financial reckoning or too much time on the golf course, contemplating a return to work. But whether you left work or not, accessing pension savings can have some unintended consequences, and you might have unwittingly walked into a pension tax trap.” 

Whether following the dream of early or semi-retirement or seeking extra funds to make ends meet, many more savers are tapping into their pension pots flexibly – in other words, withdrawing taxable amounts – once they are able to after the age of 55.  

The latest HM Revenue & Customs data showed flexible cash withdrawals from pension pots have jumped: between April and June 2023, £4billion of taxable pension payments were taken from pots by 567,000 individuals, compared with £3.4billion of withdrawals in the previous quarter made by 519,000 individuals.[2] In Q4 2017, the figure was just £1.45billion by 187,000 individuals.  

Smith continues: “Whatever the motivation behind accessing pension cash, most savers will have assumed that they could either continue to build up their pension or resume contributions and get tax relief once more if they returned to work. Indeed, the idea of plundering their pension pot in their mid- or late fifties might have been based on the assumption that they could rebuild it. 

“This plan will be hobbled, however, if they have triggered a little-known cap on the amount they can continue to save with tax-relief benefits. The Money Purchase Annual Allowance is a tax hurdle that those who have had their eyes firmly ahead on big life decisions can easily trip over.” 

What is the MPAA? 

Like the Annual Allowance it is an annual limit on the amount that can be saved into a pension with the benefit of tax-relief. At the same time as raising the AA from £40,000 to £60,000 at the 2023 spring Budget, Chancellor Jeremy Hunt also raised the MPAA from just £4,000 to £10,000. 

Smith says: “It is a substantially lower cap than the AA because the authorities decided they needed a measure that prevented retirees recycling pension income back into their pension to take advantage of tax relief twice over. 

“Not only does it restrict savers’ ability to make tax-relieved pension contributions going forwards, it also wipes out the benefit of being able to use up to three previous years’ worth of Annual Allowances under ‘carry-forward’ rules. Using carry-forward allowances can be a very useful tool for business owners with uneven earnings and those who might come into a lump sum that they want to put into their pension, so for them this is a further penalty of the MPAA. 

“While the welcome increase to £10,000, which kicked in in April 2023, gives savers a bit more leeway to rebuild their pension pot with tax benefits, the best tactic for those who want maximum flexibility is not to trigger the MPAA in the first place, if possible.”  

Who is subject to the MPAA? 

The MPAA can apply to anyone who has accessed their pension pot flexibly, the most common examples of which are: 

  • If you take your entire pension pot as a lump sum 
  • If you start to take amounts from your pension pot which are in part taxable - otherwise known as uncrystallised funds pension lump sums (UFPLS) 
  • If you move all or part of your pension pot into drawdown and start to take an income
  • If you use your pension fund to purchase a flexible annuity or one that isn’t guaranteed for life.

Smith says: “While UFPLS might sound like an obscure piece of financial jargon, it’s actually probably one of the more common ways that someone might unwittingly trigger the MPAA. If you want to access your pension early, but you don’t want to crystallise and choose whether to put your pension into drawdown or an annuity, then dipping into a pot by taking one or more small lump sums looks like an attractive option. 

“However, unlike taking the 25% tax-free lump sum all in one go, 25% of each UFPLS is tax free and the remaining 75% is taxed at the saver’s marginal rate. For some retirees in certain circumstances this can be a sensible way to access their tax-free cash, but it is counted as flexible access and triggers the MPAA. 

“Those looking to access pension savings early and avoid triggering the MPAA should not despair, as there are options.”  

What sort of pension access doesn’t trigger the MPAA?  

Smith says: “You can take your tax-free cash as a 25% lump sum and not trigger the MPAA – but it depends on what you do with the rest of the pot.” 

  • You take a tax-free cash lump sum and put the remainder of your pension pot into drawdown but don’t take any income 
  • You take a tax-free cash lump sum and buy a lifetime annuity
  • You just buy a guaranteed annuity
  • You cash in a small pot of less than £10,000 [2]

Smith adds: “The first option is likely to stand out for many of those thinking of dipping into their pension savings while keeping the option of making substantial future contributions up to the Annual Allowance. 

“However, releasing tax-free cash does require you to crystallise part or all of your pension funds - this is why the official term for tax-free cash is a ‘pension commencement lump sum’ (PCLS). A decision needs to be made in relation to what you then do with the non-tax-free element. There is no requirement for you to take an income from this portion of your pension fund and it is only when you do release some income from it that will trigger the MPAA.  
 
“In fact, much of the confusion over the MPAA might come from the distinction between crystallising a pension and accessing it flexibly.”  

MPAA and defined benefit pensions 

The MPAA only applies to contributions to defined contribution pensions and not defined benefit pension schemes.  

So even if you’re subject to the MPAA, you can still save the standard £60,000 annual allowance into a defined benefit scheme if you’re lucky enough to be in one – that is assuming you make no contributions to a DC pension scheme. 

You could also save the maximum £10,000 a year into the DC scheme, and then you would be able to save £50,000 with tax relief into the DB scheme (known as the alternative annual allowance), giving a combined pension savings total of £60,000.  

NOTES 

[1]Economic labour market status of individuals aged 50 and over, trends over time: September 2023 - GOV.UK (www.gov.uk) 

[2] HMRC: Private pension statistics commentary September 2023