Pension Questions Answered: Understanding the Money Purchase Annual Allowance (MPAA)
In our ongoing weekly series, we invite readers to submit their queries regarding retirement and pension savings to our expert, Tom Selby, who serves as the director of public policy at investment platform AJ Bell. Tom possesses extensive knowledge about pensions, and there is virtually nothing he isn’t familiar with in this domain. If you have a question for him, feel free to email us at [email protected].
Question: Why is the seemingly unfair Money Purchase Annual Allowance (MPAA) permitted to exist? A friend of mine had a defined contribution pension worth £50,000, which he was compelled to liquidate during the Covid pandemic. In contrast, I have a defined benefit pension that is significantly larger but remains below the previous £1 million lifetime allowance. After the pandemic “retirement,” we both returned to work, and I now earn over £100,000. I can contribute up to £60,000 to my pension from my current earnings. However, my friend, who earns the same amount, is restricted to a mere £10,000 MPAA, despite needing the pension more. Why hasn’t this apparent disparity been addressed?
Answer: Let’s break down some of the key terminology before we delve into your main concern. A defined benefit (DB) pension is a scheme that guarantees a retirement income based on your average salary or final salary, typically from a specified “normal retirement age.” This age is defined by the pension scheme and is often aligned with the state pension age, although this is not always the case.
In contrast, defined contribution (DC) pensions consist of a pot of money accumulated over your working life. Contributions to DC pensions benefit from initial tax relief and tax-free investment growth, and the funds become accessible starting at age 55 (which will increase to age 57 by 2028). When you access your DC pension, you can withdraw up to a quarter tax-free, while the remainder is taxed as regular income.
To manage the costs associated with providing tax relief on pension contributions, there are limits on how much you can contribute each tax year while still receiving tax relief. Initially, there is an overall annual allowance set at £60,000, which encompasses employer contributions, personal contributions, and the associated tax relief. Moreover, the maximum amount you can personally contribute to a pension each year (including tax relief) is capped at 100% of your earnings.
To add complexity, there are two distinct annual allowances that may apply under certain circumstances. If you are a high earner, you might encounter the tapered annual allowance, which reduces your annual allowance to a range between £10,000 and £60,000, depending on your earnings level. Additional details about this can be found here.
Furthermore, if you “flexibly access” taxable income from a DC pension, as your friend has done, the money purchase annual allowance (MPAA) is activated, which reduces your annual allowance from £60,000 to just £10,000. Flexibly accessing your pension mainly includes taking taxable income through drawdown, where your pension pot remains invested while you draw an income, or through taking an ad-hoc lump sum (known in technical jargon as an “uncrystallised funds pension lump sum” or UFPLS), where a quarter of that lump sum is tax-free, while the remaining portion is taxed as income. Triggering the MPAA also results in the forfeiture of the ability to “carry forward” any unused annual allowances from the previous three tax years to the current tax year.
It’s important to note that the MPAA does not apply when someone simply takes their tax-free cash, accesses a DB income, or purchases an annuity (a guaranteed income for life paid for by an insurance company). Additionally, individuals can withdraw up to three “small pot lump sums” worth £10,000 from personal pensions—and an unlimited number from occupational DC pensions—without triggering the MPAA. To qualify as a small pot lump sum, the withdrawal must fully deplete the entire pot.
As for the rationale behind the MPAA, its purpose is to prevent individuals from excessively recycling their pensions to generate additional tax-free cash. Although specific regulations exist concerning recycling, the government deemed it necessary to implement the MPAA as an additional safeguard to protect the Exchequer when the “pension freedoms” reforms were introduced nearly a decade ago.
