Quite often in my day to day role as an independent financial adviser, I am often asked a range of questions such as “do I need a pension?”, “how much should I pay into my pension?” and more recently, “should I cash in my pension?”
This article will help you decide whether or not you should cash in your pensions:
What do I need to think about before cashing in a pension?
Pension Freedoms changed the way we access our pensions and provides huge flexibility for those at retirement age. However, there is one little known piece of legislation that could cost you thousands in missed tax relief. This is known as The Money Purchase Annual Allowance (MPAA), it limits the amount you can pay into your pension and receive tax relief, to £4,000 per annum. You will trigger this if you draw taxable income from a defined contribution pension. This article will explain how the MPAA could effect you and how you can look to avoid it where possible.
How does the MPAA work?
The MPAA will apply to you if you begin withdrawing money from your pension as “flexible income” and typically it applies when you:
- Withdraw your entire pension as a lump sum (This is also known as an uncrystallised pension funds lump sum or UFPLS)
- Begin taking income from a flexi access drawdown pension – Note, this is only when you begin taking taxable income. If you just take your 25% tax free cash and no income, the MPAA will not be triggered.
- For older style drawdown plans, if you are in Capped Drawdown and exceed the withdrawal limit.
- Purchase a flexible annuity.
An important point to note is that the MPAA only applies from the day you have accessed your benefits flexibly, so for example, if you trigger the MPAA in February of the tax year, your contributions before that point will not be effected by the charge.
What effect could the MPAA have on me?
Many decide to cash in their pensions whilst they are still working. If you are employed by a company, you are likely to be receiving employer contributions and you’ll be contributing too. If combined, the contributions exceed £4,000pa you will have to pay tax charges on the excess.
Why should you care? I encounter many clients who have plenty of cash savings but little or nothing in their pension or company directors who want to extract monies in a tax efficient way. If somebody is earning £40,000 and has £32,000 in the bank, that £32,000 can be turned into a pension contribution to get them an immediate tax relief of £8,000, making their £32,000 up to £40,000 instantly (You are entitled to even more tax relief if you are a higher rate tax payer!).
Jane’s story
Jane is a Ltd company director, she is 56 years old and decided to access her pensions to treat her family to an all expenses paid family vacation. She has a number of pensions dotted around from previous employments, totalling £200,000. One of them was worth £20,000 in isolation, so she decided to withdraw this pension in full, paying income tax on £15,000 and receiving £5,000 tax free. Not bad you might think.
However, a year or two later the business has gone from strength to strength and Jane has no desire to retire.
She speaks to her friend Mike who runs his own Ltd company and he tells her that she can extract profits from her business free from income and corporation tax. So she decides she will start contributing £15,000 a year to her pension.
What’s the issue?
The problem is she triggered the MPAA a few years ago, so now she is limited in her contributions and can only contribute a maximum of £4,000 a year. Triggering the MPAA has now massively restricted Jane in how much she can contribute to her pensions. If Jane decided to just withdraw tax free cash only and not take taxable income, she would still have her £40,000 annual allowance and would be able to continue tax efficiently extracting profits and building up her pension pots.
This one decision could potentially cost Jane thousands of pounds in tax over the next few years and it could have been avoided with some prudent planning.
If you are considering cashing in your pensions and would like independent pension advice, please get in touch via the details below. The first meeting is always on us.
T: 01268 944122
E: p.denning@sterlingandlaw.com
To find out more please visit About us – Sterling & Law – Rayleigh