Beware the early pension tax trap: Savers told not to make unnecessary early withdrawals
Savers are being warned not to make unnecessary early withdrawals from their pensions or risk triggering a costly tax trap.
With the Covid-19 crisis straining household finances, experts fear many could resort to dipping into their pension pots early.
But doing so could mean those savers will only be allowed to put £4,000 a year back into a pension without leading to a tax bill.
With the Covid-19 crisis straining household finances, experts fear many could resort to dipping into their pension pots early
A survey last month showed one in 10 over-55s has either already accessed or plans to access their pension pot earlier than anticipated as a result of Covid-19.
But under the pension freedoms introduced five years ago this month, savers who make any drawdown or lump sum withdrawals will trigger what is known as the Money Purchase Annual Allowance (MPAA).
This shrinks the amount you can save each year without paying tax from £40,000 to £4,000.
It means a saver who put £10,000 into their pension would therefore then face an annual allowance charge on £6,000.
This charge is designed to recoup tax relief already received, so it would cost a basic 20 per cent rate taxpayer £1,200 and a higher rate 40 per cent taxpayer £2,400.
Data from the Financial Conduct Authority shows nearly 650,000 people accessed their pension for the first time in the 2018/19 year.
More than 300,000 of these savers risked triggering the MPAA because they either withdrew their whole pot or faced an income tax charge on their withdrawal. Those who buy an annuity or take their tax-free cash do not trigger the MPAA.
Industry experts are now calling on the government to either scrap or increase the allowance. Tom Selby, of investment broker AJ Bell, says: ‘Given the pressure placed on incomes from Covid-19, there will be people turning to their pensions to cover a short-term gap.
‘If they do this — and it might be logical for some — their ability to rebuild their pension savings when this is all over is dramatically reduced. The Government should increase the MPAA, or remove it.’
Ian Browne, from wealth management firm Quilter says: ‘The MPAA is an absurd tax which jars with pension freedoms.
‘It is right to make use of the flexibility the freedoms have introduced. Yet, thanks to this quirk within the tax system, people need to be careful how they tap into the money that is theirs.’
The Association of British Insurers has said if you take money out of a small pension pot of under £10,000 you do not trigger the MPAA.
Old Mutual Wealth, Quilter’s UK platform, allows advisers to create up to three small pots from one big pot. Mr Browne adds: ‘It is vital to seek professional financial advice first.’