PENSION TRAP – DON’T GET CAUGHT

Saving pots for emergencies provide an important buffer for when times get tough. But many without adequate nest eggs have been forced to raid their pension savings either to bolster their own income or to help family over the last 18 months.

A total of 1.4 million people cashed in £9.4billion throughout 2020 under the financial strain caused by lockdowns, according to official figures[1].

While the pension freedoms, introduced in 2015, allow savers to access every penny of their retirement savings, there are important consequences of drawing on that money. Once you have dipped into your pot, the amount of money you can pay into it -and claim tax relief on- reduces.

That’s because withdrawing income (over and above the 25% tax-free lump sum) usually triggers the Money Purchase Annual Allowance (MPAA), which reduces the amount you can pay in with tax relief by 90% from £40,000 to just £4,000.

Once you’ve triggered the allowance you can’t go back to putting a higher amount in. It’s irreversible.

When the MPAA is applied you also lose the ability to carry forward up to three years of unused allowances in the current tax year.

This sting in the tail could severely limit the amount you’re able to save for the future.

New research[2] from Canada Life has shown that nearly one in ten of over 55s have accessed their pensions while on furlough to help make ends meet. Many over 55s have flexibly accessed their pensions, with 7% using both their tax-free cash and drawing down additional sums.

However, two fifths of people were unaware of the restrictions on the amount they can continue to contribute to their pension pot.

Worryingly, 40% are aware of the restriction but are uncertain about the detail. Many overestimated the allowance as almost £7,000 a year – almost double the real MPAA limitation of £4,000.

Consulting a financial adviser before accessing pension savings early is the smart move as you could struggle to get retirement plans back on track with the lower limit in play.

Yet many of those who dip into their pension fail to take advice.

Anyone who has started taking money from a private pension –whether it be a one-off lump sum withdrawal or a regular monthly amount – must first convert their pension into an income drawdown account. Drawdown allows you to take out what you need, and leave the rest invested in the stock market.

Worryingly, an estimated 100,000 drawdown plans are taken out each year without the guidance of a financial adviser[3].

This is significant because an adviser would be able to flag up the pitfalls and important tax consequences.

It’s not just the MPAA you need to be aware of. You can also be hit with a large tax bill when withdrawing money from your pension. After the 25% that you are allowed to take tax-free, any amount withdrawn is taxed at your normal income tax rate.

Raiding a pension could also impact future benefit claims, for example support with council tax or affect universal credit claims.

An adviser can also, crucially, assist with ways in which you can take money out of your pension without triggering the MPAA.

There have been a number of campaigns among pension providers urging the Government to scrap the MPAA. However, this is not to be relied upon.

Source:

[1] https://www.gov.uk/government/statistics/flexible-payments-from-pensions#history 

[2] https://www.canadalife.co.uk/news/nearly-half-of-furloughed-workers-make-changes-to-their-retirement-plans/ 

[3] https://www.fca.org.uk/news/press-releases/fca-proposes-rules-investment-pathways-and-other-measures-improve-retirement-outcome%20s-consumers