Pension savers making use of the pension freedom reforms are being warned to choose carefully which pot they withdraw from if they only intend to withdraw under £10,000 and have a small pot.

Royal London director of policy, Steve Webb, is warning savers of a little known tax rule, which applies to small pension pots.

Those who are unaware of the rule, who end up withdrawing from the ‘wrong’ pot, could see their ability to save slashed by up to 90 per cent, Webb has said.

Following the introduction of the pension freedoms in April 2015, the government introduced a limit on the amount people could put back in to pensios once they have started withdrawing taxable cash.

This limit is known as the Money Purchase Annual Allowance (MPAA) and was originally set at £10,000 per year, but has since been cut to £4,000 per year. This compares with the standard annual allowance of £40,000. In general, savers are affected by the MPP if they withdraw money out of a DC pension above the 25 per cent tax-free lump sum.

But there is a little known exception to this rule. Those who take everything out of a ‘trivially’ small pension pot under £10,000 do not trigger the MPAA. Therefore, if an individual has two pensions and wants to withdraw less than £10,000, they should think seriously about cashing 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, they retain the ability to put up to £40,000 into a pension each year in future, rather than having this slashed to £4,000.

Consider, foror example, someone with two pension pots, one worth £4,000 and one worth £20,000 and they want to withdraw £9,000 (before tax). If they cash in the £4,000 pot in full and take just the 25 per cent tax free lump sum out of the larger pot, they will not trigger the MPAA. But if they take the full £9,000 from the larger pot they will trigger the MPAA, which will reduce by 90 per cent their annual allowance going forward.

Commenting, Webb 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. 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”.

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