Pensions: take your lump sum and run

Feeling nervous about pension provision? You should be. It is no secret that our money-hungry Treasury has earmarked tax breaks on pension savings as a great place to claw back cash. That’s partly because the tax breaks are quite generous and, of course, because very few people understand them well enough to kick up a huge fuss if they are fiddled with.

A new Institute of Fiscal Studies (IFS) report makes the point depressingly well. It notes that around 75% of contributions to UK pensions escape national insurance contributions (NICs) altogether. Why? Because they are paid into schemes by our employers before incurring any tax.

For staff, this is good reason to invest in a pension via an employer rather than out of net salary – you can reclaim income tax on later contributions, but not NICs.

But for the tax authorities it is an infuriating missed tax trick. Changing it, says the IFS in its annual appraisal of the UK economy (the “green budget”), would bring in an extra £10.8bn a year in tax – real money.

That’s not the end. The IFS also has a go at the current tax-free withdrawal system. Right now, anyone taking their pension can get 25% out immediately, tax-free (anything after that incurs income tax).

So, those with the biggest pensions under the current £1.25m lifetime limit can take £312,500 as a lump sum. There is, says the IFS, “a powerful case” for capping this “at a level considerably below £312,500”.

The IFS leaves it there. It reckons, rightly, that after so many changes to our pension system, “reducing the annual allowance or lifetime limits or restricting income tax relief on pension contributions in any other way would be expensive to administer and arguably unfair and would inappropriately distort behaviour”. But here’s the problem.

Governments in financial trouble tend to take what they can get, rather than what it is fair to get. So it makes sense to suspect they’ll listen to the first bit of the IFS’s suggestion, but not the second.

So, don’t be surprised to see a new limit on lump-sum withdrawal (we know this has been discussed); don’t be surprised to see a gradual removal of the NICs relief on contributions; and don’t be surprised to see new limits on both annual and total pension contributions.

What should you do? Take your lump sum sooner rather than later. Make your pension contributions early – particularly if you want to use lump sums rather than regular payments. Finally, don’t save too much inside a pension.

Given the ongoing uncertainty, and the obvious temptation for governments of a large pot of captive cash, you don’t want to make your retirement dreams too much of a tax target.