Is the proposed clampdown on pension tax relief a step too far?

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Many people have used the new pension freedoms introduced in April 2015 to tap into their pension pot after the age of 55.

For those whose pension fund is simply a pot of money from which they want to draw some form of retirement income, the new choices available on using that pot have been widely welcomed.

But if you are thinking about drawing pension cash (perhaps because of a personal financial crisis) and then going back to saving again at a later stage, November's Autumn Statement had a sting in the tail that you should be aware of.

The reason for this is that when the new freedoms first came in, the government of the day was worried that a minority might take advantage of them in order to get extra tax relief.

MONEY PURCHASE ANNUAL ALLOWANCE

To see how this might work, consider someone with a not untypical pension pot of, say, £24,000. In the past you had little choice but to use it to buy an annuity. Under the new rules it is possible to take the whole lot as cash - a quarter as a tax-free lump sum and the balance drawn as taxable income.

In this example you could take £6,000 tax-free and pay basic-rate tax on the remaining £18,000, receiving a total of £20,400 after tax. If you then simply got on with your retirement then there's no problem.

But what if you instead paid the £20,400 back into a pension? You could claim basic-rate tax relief on your contribution, giving you a total of £25,500, and then withdraw the whole lot again. This would give you a £6,375 tax-free lump sum and £19,125 of taxable cash.

Deducting basic rate tax of £3,825 from the taxable part would leave you with a total of £21,675. Magically, your initial £20,400 had become £21,675. And, subject to overall annual limits, you could do the same thing again and again.

Understandably, the government was not keen on this happening. So it invented something called a money purchase annual allowance (MPAA) to try to prevent it. Under the MPAA, long as you only withdraw tax-free cash from your pension pot, you are fine.

But as soon as you draw a pound of taxable cash, your ability to contribute to a pension is slashed from the usual pre-retirement £40,000 per year, to just £10,000 per year. This £10,000 figure includes both your personal contributions and any contributions from your employer.

Although this is yet another complexity in the system, most people accepted that something of the sort was needed to prevent the sort of 'recycling' of pension cash described above.

But it was a surprise when, in the Autumn Statement, chancellor Philip Hammond announced plans to cut the MPAA further - from £10,000 to just £4,000 from April 2017 - thereby raising the government around £70 million a year.

UNFAIR PENALTY

Few commentators had seen this coming, but this suggests that 'recycling' of taxed cash from pension pots may have been more widespread than was realised.

The problem with this proposed change is that it could unfairly penalise those who are not trying to abuse the system but have simply fallen on hard times in their late 50s or early 60s, before starting to rebuild their finances.

If you were over 55 and had a spell out of work and needed cash, for instance, you might well have chosen to access your pension fund to tide you over. If things then improved and you got a decent job, you might want to start building up your pension pot again.

But if you had taken taxable cash, then under the new rules you would only be able to save £4,000 per year. This means your chances of building up a worthwhile pot before you retired would be much more limited.

Suppose, for example, you resume pension saving at the age of 58. If you plan to retire at 65, you have just seven years left.

Under the current rules you have time to build up an additional £70,000 in pension contributions (ignoring investment growth), which might deliver a pension of (roughly) £70 per week.

Under the new rules, you can build a pot of just £28,000, delivering a pension of around £28 per week.

In addition, if you have an employer who will match your personal contributions on a pound-for-pound basis, the new system allows you to tap in to only £2,000 per year of matching contributions compared with a potential £5,000 per year currently.

The desire to stop people abusing the tax relief system is understandable, but this measure does seem pretty heavy-handed, and risks penalising people trying to do the right thing. If you want to respond to the consultation, it closes on 15 February 2017.

Unfortunately, given that the consultation closes just a few weeks before the changes are due to be implemented, it is hard to avoid the feeling that the Treasury has already made up its mind about this somewhat mean-spirited change.


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