One of the great benefits of the 2015 Pension Freedoms is that many people have more options when accessing their pension. Yet one drawback is the greater temptation for some individuals to “dip” into pensions to plug an income gap – often inadvertently triggering a tax trap.
Below, our Carlisle financial planners explain how “pension dipping” can backfire and ways to protect your long-term retirement plan. We hope these insights are useful to you. Please contact us for more information or to speak with a financial adviser:
t: 01228 210 137
e: [email protected]
What is “pension dipping”?
In 2023-24, once an individual reaches their Normal Minimum Pension Age (currently age 55), he/she can start accessing certain pension benefits – assuming their scheme allows this. No longer do the funds have to be used to buy an annuity. You could go into drawdown instead.
In simple terms, this means keeping your pension money invested whilst making gradual withdrawals from it to support your lifestyle. This can be a great option for people who have planned this ahead of time using financial advice (e.g. officially entering flexi-access drawdown).
However, suddenly having access to your pension at age 55 (a lot of money for many people) can present huge temptations to “dip” into it without careful planning. In 2023, this is a particular problem due to the cost of living crisis – with inflation eroding real household incomes.
By dipping into their pension(s), some over-55s believe they can more easily pay their bills in the short term. Yet this is a risky strategy in the long term. Taking too much can risk reducing your retirement income later in life. In the worst-case scenario, you could run out of money.
Yet dipping into a pension can also have another serious repercussion – triggering a “tax trap” related to the Money Purchase Annual Allowance (MPAA).
What is the pension dipper tax trap?
In 2023-24, an individual can withdraw up to 25% of their pension benefits without a tax charge after they reach age 55. For instance, if there is £500,000 saved in your pension, you could take £125,000 either as a single lump sum or multiple lump sums without paying income tax.
Taking some (or all) of your tax-free lump sum can be appropriate in certain circumstances following advice from your financial planner. However, accessing your pension benefits could trigger the MPAA rules in certain situations – e.g. if you take your tax-free cash lump sum and put your pension pot into flexi-access drawdown.
The MPAA rules limit how much you can continue to contribute to your pension(s) each year whilst enjoying tax relief. Normally, in 2023-24 a taxpayer has a maximum annual allowance of £60,000 (or up to 100% of their earnings – whichever is lower). Within this limit, an individual can receive tax relief equivalent to their highest marginal rate.
For instance, a basic rate taxpayer gets 20% tax relief on their pension contributions. A higher rate taxpayer gets 40%. Over someone’s career, this mechanism can provide a significant “boost” to a taxpayer’s retirement fund – and, in turn, their future retirement income.
However, when the MPAA rules are activated, the individual’s annual allowance is reduced to £10,000 per year (this was increased from £4,000 in April 2023). Many people are not aware of this rule and can trigger it unwittingly when dipping into their pension to plug an income gap.
How to guard against the tax trap
Unfortunately, once activated, the MPAA rules cannot be undone in an individual’s case. Therefore, the best defence for an individual is financial education and working closely with a financial adviser who can help you to steer away from mistakes like these.
Try not to view your pension as a bank account. The latter can typically be accessed easily without triggering complex tax rules. The former, however, operates under a special system that must be navigated carefully to avoid costly mistakes in retirement.
If you have any “small” pension pots (e.g. valued under £10,000) then you can usually cash these in without triggering the MPAA rules. However, be careful to seek professional advice beforehand. There might be better options for you – e.g. consolidating the schemes into a single, easy-to-manage pot with lower fees and better funds that may offer greater investment returns.
If you have already triggered the MPAA rules, do not despair. It simply means it could make it more difficult to plan for retirement. Speak with a financial adviser to explore how to best move towards your retirement goals. Whilst certain tax-efficient “doors” may have closed or been restricted to you, there will still be strategies you can explore.
For some people, they wish to continue working (e.g. part-time) whilst receiving some pension income to support their lifestyle. This can be a legitimate option if planned for in advance – approaching the MPAA with your eyes open – using professional advice.
Invitation
If you would like to discuss your financial plan and retirement strategy, then we would love to hear from you. Get in touch with your Financial Planner here at Vesta Wealth in Cumbria, Teesside and across the North of England.
Reach us via:
t: 01228 210 137
e: [email protected]
This content is for information purposes only. It should not be taken as financial or investment advice. To receive personalised, regulated financial advice regarding your affairs please consult your Financial Planner here at Vesta Wealth in Cumbria, Teesside and across the North of England.