The proposed reduction in the Money Purchase Annual Allowance alters the dynamic of the pension freedoms and has implications for retirement planning – Kate Smith takes a closer look.
Philip Hammond’s Autumn Statement was thankfully relatively quiet in terms of pensions news. After a number of blockbuster announcements in recent years, the general consensus from the pensions and advice industry was that we could all do with a little time to let recent changes bed-in.
That said, the change to the snappily titled Money Purchase Annual Allowance (MPAA) probably made advisers’ ears prick up as it alters the dynamic of the pension freedoms and has implications for retirement planning.
The MPAA will be reduced from £10,000 to £4,000 a year next April. This means that, once clients start accessing money from a flexi-access pension, the maximum they will be able to continue paying into a pension and earning tax relief falls by £6,000.
The money purchase allowance was introduced ahead of the pension freedoms to prevent people ‘recycling’ their pension saving, which involves a process of taking money that has already received the benefit of government tax relief – 20%, 40% or 45% depending on their tax band – and then adding it back to a pension and receiving the government top-up again.
Advisers will want to highlight that the reduction in the allowance changes the dynamic of the pension freedoms and, in effect, reduces their flexibility. If clients are retiring in the traditional sense and giving up work completely to then live on their savings, then this change is unlikely to affect them.
If, however, they are planning to access their pension early, from age 55 under the pensions freedoms – perhaps to pay off a debt – then the reduction could create a problem. Instead of being able to keep saving up to £40,000 a year into a pension tax-free, the amount they will be able to pay in will fall to just £4,000 and any contributions above this will be taxed at their marginal rate.
As a result people need to be certain they are all set for retirement before accessing these savings or at least understand it will affect their ability to keep saving into a pension.
The government has argued only a relatively small number of people continue to pay in more than £4,000 once they start accessing their pension. It is still early days for the pension freedoms, however, and it is hard to build a true picture of how people are using them at this stage. Advisers might argue that many of their clients would be in position to keep paying more into their pension were it not for this new limit.
This rule highlights a general point about prioritising which savings people use up first in retirement as this can be almost as important as saving itself. The order in which clients access their money can make a big difference to how much tax they will pay and how much can be paid into their pension, making savings last longer. It could also allow clients to leave more money to loved ones following their death.
Of course everyone’s circumstances and financial needs are different but advisers are well placed to help their clients understand the significance of the order in which they access savings and to make sense of the new MPAA rules.
Kate Smith is head of pensions at Aegon
Prioritising the order in which clients access savings
1. Bank account: Clients can avoid paying income tax on any interest earned above their personal savings allowance by not holding excess cash in their bank account.
2. ISA savings: Clients can cash in their ISA at any time and, as payments are tax-free, they will not affect the amount of tax they pay. Using their ISA savings can help them top up their income when moving from full-time work to reduced hours to full retirement. ISAs form part of their estate – potentially attracting inheritance tax – although there are now special tax rules between spouses and civil partners who inherit their partner’s ISA allowance.
3. Pension tax-free cash: Up to 25% of their pension fund. They can do this from age 55 and, as the amount is tax-free, it will not affect the amount of tax they pay. Nor will taking a 25% cash trigger the MPAA limit.
4. Small pension pots worth less than £10,000: With the exception of the 25% tax-free cash withdrawal from their pension, any further income will be taxed under the income tax rules. Cashing in up to three small pension pots, however, does not trigger the MPAA limit and means they can keep saving within the annual allowance of £40,000.
5. Pension income: Clients should generally access their pension last after accessing their ISA, and pension tax-free cash, as any pension income will be taxed under the income tax rules. This will also help their retirement income last longer.
If they are still working, clients may want the option of keeping on making pension savings. They should be aware that, once they take retirement income from income drawdown or a flexible annuity pension, savings will be limited to £4,000 a year, down from £40,000 from April 2017, which could affect your future plans.
They also need to be careful how much they take out in any tax year to avoid crossing a tax band and paying more tax then they need to. It may be worth them taking some pension income alongside income from other savings if they would still be below the income tax threshold.
Special rules apply to pensions in the event of the client’s death, and they do not normally form part of the estate. If they die before age 75, their unused pension funds can be paid tax-free to loved ones either as a lump sum or income. This also applies to annuities if they had bought a dependant’s annuity. If they die on or after age 75, any unused pension, or dependant’s annuity is taxed at their loved one’s income tax rate.
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