What is a money purchase annual allowance?
Money purchase annual allowance (MPAA) was introduced in 2015 as part of the Pension Freedoms. It restricts the amount of tax relief you can collect on contributions you make once you start drawing benefits from your pension in certain ways, as explained later in this article.
But exactly “what is money purchase allowance?” in more detail, what are the rules how does it work and what triggers it?
What is the money purchase annual allowance?
If you begin withdrawing a taxable or flexible income (I.e. not tax-free cash) from a defined contribution pension pot (the most common form of pension), the amount that can then be contributed to the pot, while still receiving tax relief, may be reduced. This is what’s known as the money purchase annual allowance.
The money you put into a pension attracts income tax relief at your marginal rate of tax, which could be basic rate at 20%, higher rate at 40% or additional rate at 45% (different rates apply to Scottish taxpayers), but it is not without limits.
You can receive tax relief on up to 100% of your relevant UK earnings. However, the annual allowance for the current year is £40,000, therefore a potential tax charge may arise for contributions above this level. Although, it is possible to make a contribution above this level where you have sufficient unused pension allowances available from any of the past three tax years (these can be carried forward). However, if you trigger the MPAA, this allowance will drop down to just £4,000 per year.
Note that MPAA is only applicable to defined contribution pensions and not defined benefit pensions (also known as a final salary scheme). A defined contribution pension, which is sometimes referred to as a money purchase scheme, can be either a private or a workplace pension which involves you and/or your employer making contributions towards your pension pot. The amount of your pension you will have at your disposal in retirement depends on the amount contributed to this pot. A lot of the working population of the UK will have a defined contribution pension since auto-enrolment was introduced in 2012.
What are the money purchase annual allowance rules?
It’s important that you have a firm grasp of the rules surrounding MPAA. Here they are in brief:
- The MPAA sets a lower annual allowance for pension contributions, and in relation to defined contribution pensions, it is triggered by drawing a taxable income payment. The MPAA is not triggered when only tax-free cash is drawn.
- The scheme isn’t a replacement for the current annual allowance rules which are still in force for those who do not trigger MPAA. In short, normally your annual allowance is £40,000 for the year (this allowance is tapered where your income exceeds certain thresholds).
MPAA can be triggered by a number of circumstances, which are explored in the following section.
What triggers money purchase annual allowance?
Put simply, drawing income from a flexible-access drawdown plan or uncrystallised (a pension becomes crystallised as soon as you access the funds) pension lump sum (i.e., taking an ad hoc sum from your self-invested personal pension, after the age of 55, which is comprised 25% of tax-free cash and 75% of taxable income) will trigger the money purchase annual allowance.
However, there are additional circumstances which may trigger MPAA. These include when somebody with a capped drawdown chooses to change to flexible-access drawdown or exceeds their current Government Actuary’s Department income limit. It will also be triggered when an individual purchases a flexible annuity.
In summary, MPAA triggering events include:
- Withdrawing your whole pension pot in one lump sum.
- Withdrawing a series of taxable lump sums from your pension pot.
- Setting up a drawdown scheme and drawing income from it.
- Having a capped drawdown plan and surpassing the cap on your income.
- Buy a flexible or investment-tied annuity which sees variations in income.
You may be exempt from MPAA pension limits if you meet the following criteria:
- You withdraw one lump sum only which doesn’t surpass your 25% tax-free allowance.
- You use your pension to buy a lifetime annuity.
- You cash in a small pension pot which has a value of £10,000 or less.
It’s important to understand that if you exceed the money purchase pension plan contribution caps, you will have to pay a tax charge according to your income tax band.
In most cases, when making contributions to your pension, you have the right to use the carry forward rule, which allows you to claim unused allowance from any of the three previous tax years. However, if you are already liable for money purchase annual allowance, you cannot utilise this carry forward rule.
Be aware that the MPAA of £4,000 will not be in place until you begin drawing from the taxable portion of your pension. Until that point, the annual allowance limit (currently £40,000) will remain in force, subject to the the level of your net relevant earnings.
Be warned: Fines for not adhering to MPAA
If you trigger the MPAA, you will be informed by your pension scheme administrator. However, from that point onwards, it is up to you to provide the relevant information about your financial situation to any and all pension providers you are saving with. You have 91 days to do this. If you do not, you may be forced to pay a £300 fine and subsequent daily fines of £60 until you do so. Naturally, you want to avoid finding yourself in this situation, so make sure you take initiative and inform all relevant parties before the 91 days are up.
So, in summary, when asking "what is a money purchase annual allowance?" in short, the MPAA restricts the amount that you can contribute to a pension in a tax year without incurring a tax charge. This allowance is currently set at £4,000, although back in 2017 it was £10,000 and is only triggered once you start flexibly accessing the taxable part of your pension.
The main triggers for MPAA are:
- Taking an uncrystallised funds pension lump sum (accessing a lump sum from your pension which is a combination of tax-free cash and taxable income).
- Withdrawing several taxable lump sums from your pension pot.
- Withdrawing income from a drawdown scheme.
- Surpassing the limits on income from a capped drawdown plan.
- Having a flexible or investment-tied annuity which has a variable income.
How can we help?
MPAA is fairly complex to navigate, and you can unexpectedly find yourself in an unfavourable tax position, or even liable for fines. Seeking out financial guidance can help you steer your pension plan in the right direction, while allowing you to get a firmer grip on the relevant rules, regulations and tax responsibilities. To find out how MPAA may affect you and learn a little more about how to manage your pension overall, please get in touch to arrange a free consultation with a Financial Adviser today.
Note: The Financial Conduct Authority does not regulate Tax Advice or Estate Planning. A pension is a long term investment, the value of investments can fall as well as rise. You may not get back what you invest. Your eventual income may depend on the size of the fund at retirement, future interest rates and tax legislation.