The ability to make early pension withdrawals was one of the very welcome pension freedoms delivered in 2015. However, the world of pensions and tax remain terribly complicated with significant and expensive consequences for some actions. Obtaining professional advice on such matters is definitely recommended.
Incomes have been seriously affected by the global pandemic in the past year and those that are able to may be tempted to draw on their pension funds to make up some of the shortfall. Whilst this may be an immediate cashflow solution you should be aware of a significant tax trap if you do this whilst continuing to earn an income.
Individuals are able to invest a maximum of £40,000 pa into a pension scheme each year saving a great deal of income tax in the process. This allowance is a very important aspect for personal tax planning and where possible it should be exploited to the fullest extent.
However, if you withdraw funds from your pension pot in excess of the 25% tax free amount this annual allowance reduces dramatically to £4,000 pa. If you have retired and no longer pay into your pension this isn’t an issue but if you are continuing to earn and contribute to the pension then it will severely limit the tax benefits available to you in the future.
The £4,000 limit is referred to as the Money Purchase Annual Allowance (MPAA) and once it is triggered this cannot be reversed.
Money Purchase Allowance Rules
Thankfully there are some exceptions that provide a small degree of flexibility – there are always exceptions where tax is concerned ! The MPAA will not be triggered where:
- An amount up to the 25% tax free amount has been withdrawn from the pension fund and the remainder either stays invested or is converted into a lifetime annuity
- The entire fund is cashed in when the value is less than £10,000 – this can be done up to three times in a lifetime
Given the complexity of this area anyone considering a pension cash withdrawal is strongly advised to take professional advice. Whilst we as accountants can discuss and explain tax rules this really is the remit of a regulated independent financial adviser. If you do not currently have a financial adviser you may choose to talk to friends who can recommend a local professional or perhaps take a look at Unbiased.co.uk to identify one in your area.
You can also read more about this subject on the Pensions Advisory Service website