Pension dipping shock – 2 million over-55s hit by ‘punishing’ tax rule. ‘Caught unawares’

The over-55s are free to dip into their pension and take cash lumps sums as required, but there is a hidden penalty for doing so. Almost two million have risked getting caught out since flexible pension freedom reforms were introduced in April 2015.

Pension freedom reforms were hugely popular as they scrapped the obligation to buy an annuity at retirement, but there is a hidden pitfall.

The moment you start withdrawing cash from your pension, you risk reducing the amount you can invest in future.

Saver who take just a bit of cash from their pension savings risk inflicting long-term damage on their retirement plans.

It’s due to something called the Money Purchase Annual Allowance, or MPAA, which was introduced to stop people drawing money out of their pension then immediately paying it back into claim tax relief on their contributions.

HM Revenue & Customs don’t want savers to continuously “recycle” their pension money in this way, but its solution is brutal.

Many will be hit without knowing it.

The moment you draw money from a defined contribution pension, whether a company or personal pension, the amount you can invest in future while claiming tax relief crashes to a maximum £4,000 a year.

There are tax penalties if you exceed that sum, while you also lose the ability to carry forward unused pension allowances from previous tax years.

So a saver who withdraws money from their pension soon after turning 55 and incurs the MPAA could unwittingly slash the amount they can save into a pension for life.

Almost 300,000 over-55s made pension withdrawals in 2001 yet research from Canada Life has shown that two in five are unaware this restriction exists, while a similar proportion are uncertain about the detail.

The total number at risk is growing every year, says Stephen Lowe at retirement specialist Just Group. “Nearly 1.9 million pension savers have become subject to onerous MPAA rules in the seven years since pension freedom reforms were launched.”

READ MORE: Pension lifetime allowance & MPAA tax costs to rise – advice issued

While £4,000 a year sounds like a lot to invest in a pension, Lowe cautions: “It is only about £266 a month for a basic rate taxpayer and £200 a month for a higher rate taxpayer. This includes both their own and any employer contributions.”

This may not be a problem for those giving up work and drawing money from the pension in the traditional way.

However, it could spell disaster for those who do not intend to retire but take just one flexible payment, say, to see them through a sticky patch in their 50s or early 60s, Lowe said. “They are then forever subject to the MPAA which could prevent them from catching up on their retirement savings later.”

Every week, more than 1,000 people draw money from their pension pot without taking advice or guidance, and may not understand the dangers of taking their first flexible payment.

Many over-55s have been caught unawares by the MPAA after dipping into their pension for short-term financial support, says Steven Cameron, pensions director at Aegon.

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Cameron would like to see the MPAA increased to £10,000, to allow people to to get their retirement planning back on track.

“While these rules were introduced to stop people recycling their pensions cash, the reality is that it is punishing hard working people,” he says.

The MPAA is triggered if you take your entire pension as a lump sum, draw ad hoc sums, or shift it into a flexi-access drawdown scheme and take income from that.

It won’t normally be triggered if you take a tax-free cash lump sum and use it to buy a lifetime annuity that provides a guaranteed income for life, or put your pension pot into a drawdown scheme but do not take any income from it.

Becky O’Connor, head of pensions and investments at Interactive Investor, said: “The MPAA does not apply if you take up to 25 percent of your pension as a tax-free lump sum.”

It also doesn’t apply if you cash in a number of small pension pots each valued at less than £10,000.

The rules are complex and Lowe warns: “Many risk getting caught.”