Are you investing for the long term? One of the best tools for growing tax-efficient wealth is to use a pension. Not only can this “wrapper” protect your investments from taxes on dividends and capital gains, but it also lets you boost your contributions using tax relief.
However, pensions can be complex to navigate, making many investors vulnerable to costly mistakes. In particular, the Money Purchase Annual Allowance (MPAA) rules can act like a trap for even the best-intentioned investors.
Below, we explain the nature of the MPAA trap, why investors fall into it, and how you can shield your portfolio. We hope these insights are helpful. If you want to ensure you’re taking the right steps to safeguard your financial future, please get in touch.
What is the MPAA trap?
The Money Purchase Annual Allowance (MPAA) is a rule restricting how much an investor can contribute tax-efficiently to their pension. If the rule is triggered, it can significantly hinder your ability to build a nest egg.
To understand this, let’s recall how the UK’s pension system works. In 2024-25, you can claim tax relief whilst making pension contributions of up to £60,000 per year (or up to 100% of your earnings – whichever is lower). This is called your annual allowance.
Tax relief is equivalent to your highest marginal tax rate. A basic rate taxpayer gets 20% relief, which means it effectively “costs” them just 80p to make a £1 pension contribution.
Those paying the higher and additional rates get an extra 20% and 25% relief, respectively. This extra relief must be claimed via Self Assessment.
These reliefs can significantly boost someone’s pension contributions. This is where the Money Purchase Annual Allowance (MPAA) can be a problem. If triggered, it can reduce a taxpayer’s annual allowance to just £10,000.
What triggers the MPAA?
The MPAA is triggered when an individual flexibly accesses their defined contribution (DC) pension. If you take flexible benefits from your pension, your annual allowance will be restricted to £10,000, unless you meet specific exemptions.
Technically, this is known as taking pension benefits in a manner that allows unrestricted access to pension funds. One notable exception is when someone takes their 25% tax-free lump sum (i.e. the Pension Commencement Lump Sum, or PCLS). Another exception is buying an annuity.
Here are some specific triggers for the MPAA:
- Taking a Flexi-Access Drawdown Income – If you start withdrawing income from a Flexi-access drawdown fund (beyond the tax-free lump sum).
- Taking an Uncrystallised Funds Pension Lump Sum (UFPLS) – If you withdraw a lump sum directly from your pension where 25% is tax-free, and 75% is taxable.
- Converting a Capped Drawdown to a Flexi-Access Drawdown and Taking Income – If you were in a capped drawdown arrangement and start taking income beyond the capped drawdown limit, the MPAA applies.
- Taking a Scheme Pension from a DC Scheme with Fewer than 12 Members – If your pension provider offers a scheme pension but there are fewer than 12 members, the MPAA may be triggered.
- Receiving Standalone Lump Sums from a DC Pension (in some cases) – If your pension scheme allows a lump sum withdrawal where 100% is tax-free, and it doesn’t meet certain exemptions, the MPAA could be triggered.
The impact on investors
If you want to invest to achieve your retirement goals, you may want to use a pension due to its attractive tax benefits. However, triggering the MPAA too early could significantly set you back.
For instance, under normal circumstances, investors can use the “carry forward” rule to utilise unused pension allowances from the previous three years. This could conceivably allow an additional rate taxpayer to put £180,000 into their pension in a single tax year, claiming tax relief in the process. However, if the MPAA rule is triggered, carry forward can no longer be used.
Another possible scenario is an investor triggers the MPAA rule unwittingly, then continues their pension contributions of over £10,000 per year. This introduces a tax charge on the excess amount, effectively removing the tax relief the investor thought they were gaining.
Navigating the MPAA
Avoiding the MPAA trap involves educating yourself about the MPAA “triggers” and avoiding them until you are ready. A financial adviser can give you the clearest picture of the MPAA tax “landscape” and how to avoid common investor mistakes.
However, there are still options if you have already triggered the MPAA rules. In particular, VC schemes such as Venture Capital Trusts (VCTs) and the Enterprise Investment Scheme (EIS) offer tax-efficient investment opportunities, though they differ from pensions in structure and risk profile.
Two notable examples of these schemes are (Venture Capital Trusts) and EIS (the Enterprise Investment Scheme). Both offer unique ways to build tax-efficient wealth.
For instance, VCTs let investors receive general tax-free dividends. EIS investments may qualify for Business Relief (potentially reducing inheritance tax liability) and can allow investors to defer capital gains tax when reinvesting
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