Many savers entering drawdown are unaware they can avoid triggering the money purchase annual allowance if they split their pension into smaller pots.
Analysis by Royal London revealed savers may see their ability to save into a pension significantly reduced if they take money from the wrong pension pot.
The MPAA, introduced in 2015 to coincide with pension freedoms, is the amount a person who has already begun drawing on their pension can pay back into their retirement pot in a given year without incurring a tax charge.
The allowance was cut from £10,000 to £4,000 in April 2017 because the government said it wanted to ensure savers were not recycling cash through their pension.
The MPAA is triggered when a person continues to take money from their pension beyond the 25 per cent tax-free lump sum.
But Royal London highlighted there is an exception to this rule as individuals who take all their money from a pension pot worth under £10,000 do not trigger the MPAA.
Therefore Royal London suggested that someone with two pensions who wanted to withdraw less than £10,000 should cash in a small pot in full rather than taking a partial withdrawal from a larger pot, as this avoids triggering the MPAA.
As a result, the saver retains the ability to put up to £40,000 into a pension each year in future, rather than having this slashed to £4,000.
Steve Webb, the director of policy at Royal London who was pensions minister when the MPAA was introduced, said: “Last year, over half a million people aged 55 or over made flexible withdrawals from their pension, and many of these withdrawals will have been for amounts under £10,000.
"If they emptied out a small pot then this will have had no impact on their future ability to save into a pension. But if, by mistake, they took the same amount as a partial withdrawal from a bigger pot, they risk triggering stringent HMRC limits on future pension saving."
He added: “Those with more than one pension pot should consider very carefully the order in which they access these funds, especially if they may want to contribute into a pension in future”.
Sir Steve explained this exception would be particularly beneficial to someone who wanted to access their pension due to a redundancy or divorce.
This person may want to save into their pot again in the future, perhaps because they got a new job that had a pension scheme.
Only being able to contribute £4,000, rather than the £40,000 annual allowance, because they had triggered the MPAA by accessing their pension pot previously could make a significant difference, Sir Steve explained.
Ian Browne, pensions expert at Quilter, agreed this exception is unknown but can have a massive impact on people’s saving habits.
Mr Browne said: “The small pots rule is a little known rule that can help an adviser add huge value to their client.
"As well as avoiding the MPAA, the small point rule is an ideal way to avoid emergency tax issues for basic rate and higher rate tax payers as the taxable amount withdrawn is only taxed at 20 per cent when paid.
“If you remain a basic rate tax payer after the payment then there is nothing further to do. If you are a higher rate tax payment then the extra 20 per cent due is paid via your self-assessment.”
Some providers design their pension products around his rule exception. For example, Old Mutual Wealth, Quilter’s UK platform, have an option that allows advisers to create up to three small pots from one big pot for their clients.
Aegon has called for the MPAA to be raised from the current £4,000 to £10,000, saying savers could too easily be caught by the limit when accessing their pensions.
According to analysis from the pension provider, published yesterday (August 13), individuals earning £30,000 who, alongside their employer, are contributing sums equivalent to 14 per cent of their salary to a money purchase pension, would be caught by the MPAA if they enter drawdown.
FTAdviser reported last September that the government isn’t able to evaluate the effectiveness of its cuts to the MPAA, because it does not have the data on how much tax is collected through this allowance.
amy.austin@ft.com
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