Key pension traps advisers can help clients avoid

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Key pension traps advisers can help clients avoid
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The majority of these overpayments happened as a result of emergency tax codes being applied to PAYE as people who were still in the workplace accessed their pension savings for the first time, or returned to work after vesting part or all of their pension. This is something Jon Greer, head of retirement policy at Quilter, describes as “a little-known quirk of the PAYE system that often results in considerable tax overpayments”.

The importance of getting advice

He says: “Once again, pension savers are being caught out by our clunky pension taxation system.

“Over the course of 2021, £142m was repaid by HMRC to pension savers, with the bulk of this in the third and fourth quarter of the year, implying that more and more pension savers are dipping into their pensions in the latter half of the year.

“This highlights the importance of getting financial advice before touching your pension. HMRC will make a repayment automatically, but this could take some time, so if you want a refund to come through more quickly, then make a repayment claim yourself to avoid waiting for HMRC.

“Working with someone who knows and understands the system and can plan your financial affairs thoroughly with you will reduce the risk of lost income being handed to the tax authorities, or if it is taken, then helping you reclaim it speedily and effectively.”

Emergency tax codes

The emergency tax code is put in place when someone makes a withdrawal from their pension because doing this in one month means HMRC will tax you as if you are taking this as regular income, says Helen Morrissey, senior pensions and retirement analyst at Hargreaves Lansdown. The result is a potentially significant overpayment if it is not caught quickly.

She says: “You can of course reclaim the extra cash, but it takes time and can come as a bit of a shock if you aren’t expecting to be taxed so much. Clients can navigate these issues themselves, but if they don’t know the problem exists to begin with then they can fall foul. Working with an adviser means they can keep an eye on these things and make sure allowances aren’t breached and that you are claiming everything you are entitled to.”

Despite the fact that the UK pension system went through what was called ‘pension simplification’ from April 6 2006, the pension system remains incredibly complex, and this is just one example of where unsuspecting pension savers can find themselves in conflict with the rules if they do not get an adviser to guide them.

More than one pensions trap

However, this is just one issue that advisers can help pension savers avoid. One of the other major issues is the amount of pension tax relief that remains unclaimed because many 40 per cent and 45 per cent taxpayers do not realise they may need to reclaim everything over the basic 20 per cent tax rebate on a self-assessment return, even if they are in a PAYE system.

Tom McPhail, director of public affairs at the Lang Cat, says: “I believe there’s the best part of £1bn a year in higher rate relief that goes unclaimed. Part of the problem is that in some pensions, full relief is given automatically, while in others, only basic rate relief is granted at source.

“So, employees can be lulled into a false sense of security. They maybe move jobs and don’t realise they’re operating under a different set of rules. People don’t always understand their payslips, their tax code and how deductions are calculated, so just assume everything is right.”

Morrissey adds: “Not [reclaiming] this can potentially leave you thousands of pounds out of pocket by the time you retire.”

Pension allowances limit even modest earners

However, not all potential banana skins in pensions relate to tax overpayments or rebates. One of the biggest problems even relatively modest earners can face arises because of the relatively low amount you can put into your pension each year once you have started accessing your pension pot.

For example, most people will have an annual allowance of £40,000 that can be put into their pension, but this is tapered if you are either a high earner or have already accessed your pension in the same year.

Morrissey says: “The money purchase annual allowance or tapered annual allowance [has] the potential to slash the amount you can put into your pension to as low as £4,000 per year. If you breach this allowance, you will be subject to a tax charge. So, it is worth checking your allowances to see what you are entitled to.”

The MPAA was introduced alongside pension freedoms “to prevent people drawing money from a pension, including the 25 per cent tax free lump sum, and recycling it back into a pension scheme to claim further tax relief on these contributions”, says Steven Cameron, pensions director at Aegon. It is triggered when people access their defined contribution pension.

The way this works means that even those on relatively moderate incomes are at risk of breaching the MPAA, with Aegon’s analysis showing that someone earning £30,000 a year and paying pension contributions on their full salary will breach the limit with monthly contributions more than 13.4 per cent, including any contributions from their employer.

Eyes wide open

Cameron adds: “Savers need to have their eyes wide open when accessing their pension to avoid the devastating consequences on future retirement plans. The little-known limit is putting thousands of older workers at risk of finding out too late that they have damaged their future pension potential.

“It could even mean that they have to opt out of being automatically enrolled into a workplace pension because their combined employer and individual contributions are above £4,000. This means they lose out on a valuable employer contribution.”

These are key areas where advisers can help pension savers not only maximise their pensions, but also prevent them from falling into some serious traps waiting for them if they try to go it alone.

Morrissey says: “There are many hidden pension pitfalls that can trip you up if you aren’t careful.”

Alison Steed is a freelance journalist