The £1m pension problem: Why you may not get 25% tax-free cash

The pension lifetime allowance is being axed, but there is a sting in the tail. Savers with large pension pots could see their tax-free lump sum shrunk to just 10%. We explain what’s happening and what action you should take

Worried businesswoman with head in hand while looking at laptop in home office
(Image credit: Getty Images)

Pension savers risk losing thousands of pounds of tax-free cash due to lifetime allowance reforms coming into effect in April.

Savers typically receive 25% of their pension pot tax-free, but this could be reduced to just 10% over the next decade.

This is because a maximum limit of £268,275 tax-free cash will be introduced in April. It is one of chancellor Jeremy Hunt’s pension reforms. Back in the March Budget, he famously declared that the £1,073,100 lifetime allowance would be scrapped. The allowance is the amount you can put into workplace pensions and self-invested personal pensions (Sipps) without being hit with a tax penalty of up to 55% when you come to withdraw it.

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But what many people did not notice was the government is also setting a maximum of 25% of the lifetime allowance (which is £268,275) as a limit on tax-free cash - and there are no plans to increase this lump sum.

It means if your pension grows to £1.5m in the next few years, the cap on the tax-free cash will remain at £268,275, which is the equivalent of just 18% of the nest egg. 

The wealth manager Quilter calls it a “stealth tax”, and warns it will have “major consequences for those who, through careful financial planning, have accrued significant pension wealth”.

Roddy Munro, the head of tax and pensions at Quilter, comments: “With savers already impacted by fiscal drag as well as the reduction in the capital gains annual exempt amount and the dividend allowance, now those with large pension funds will soon feel the full effect of the freezing of the amount they can take tax-free from their pensions.

“The government is banking on general ignorance of the impact of such fiscal drag to increase the tax take by stealth, but people can act as there are a number of ways to avoid these Machiavellian reforms.”

How fiscal drag affects pensions tax-free cash

According to Quilter, those who have reached or are set to reach the previous lifetime allowance will see the amount of tax-free cash available to them shrink in percentage terms and in purchasing power as their pension grows.

After a decade, assuming investment growth of 6% a year, a £1,073,100 pension would be worth £1,921,759. If the tax-free lump sum stayed at £268,275, a retiree could only withdraw 14% of their pension tax-free.

If you also factor in inflation at 3% a year, the value of the tax-free lump sum after a decade drops to £199,622, or just 10% of the retirement pot. 

Swipe to scroll horizontally
Row 0 - Cell 0 Pension pot valueMaximum tax-free cashTax-free cash percentageMaximum tax-free cash after inflation**Tax-free cash percentage after inflation**
Today £1,073,100 £268,27525% £268,27525%
5 years’ time £1,436,050* £268,27519% £231,41616%
10 years’ times £1,921,759* £268,27514% £199,62210%

Source: Quilter. *Assumes 6% annual investment growth. **Assumes 3% inflation.

How to beat the tax-free cash squeeze

About 1.6 million people are set to breach the previous lifetime allowance by 2026, with many more set to exceed it in the years to come.

Savers are being urged to take action over the fixed tax-free lump sum, or face a pension inertia trap.

A key consideration is at what point you decide to “crystallise” your pension. This occurs as soon as you withdraw money from it, such as your tax-free cash. 

If you crystallise your pension earlier than planned, there are two issues to be aware of. First, money that is withdrawn from a pension will lose its advantageous inheritance tax status. 

Second, you trigger the money purchase annual allowance (MPAA), which means the maximum you can contribute to your pensions in a tax year is slashed from £60,000 to £10,000 a year.

Some savers may wish to crystallise earlier than planned and invest their tax-free cash in other products to both protect and make their tax-free cash rights work harder. 

Munro explains: “Some people with larger pensions are deciding to take their tax-free cash earlier and utilise other products. Where this is the case, it is important people consider the likes of ISAs and insurance bonds to shield their long-term savings from the taxman should their pension be above the traditional lifetime allowance. Insurance bonds in particular are back in vogue following these reforms as they can help to control the tax payable, simplify tax reporting and sit within a trust for inheritance tax planning purposes.”

Alice Haine, personal finance analyst at the investment platform Bestinvest, says that if savers take their tax-free cash early they need to consider carefully that they are giving up tax-free investment growth and the money will also be liable for inheritance tax.

She adds that there are a "lot of ifs, buts and maybes, because Labour may win the next general election and change the pension game once again". 

"In theory, [if Labour win], those that decide not to cash in now and instead focus on topping up their pension while they can, even breaching the previous lifetime allowance in the process, may be able to lock in a fresh deal at a higher level [such as fixed protection, where you keep a higher lifetime allowance figure and in turn a higher tax-free cash sum]."

Meanwhile, savers with defined benefit pension schemes may also be worried about the tax-free cash rules coming into effect in April. 

Munro notes: “These savers may have to consider more complex planning to protect their tax-free cash amount. This is against the backdrop of an election year in 2024, which could see Hunt’s pension reforms reversed if Labour come to power. The best outcome for consumers will very much be driven by their own and their family’s circumstances, so taking professional advice will be critical.” 

Ruth Emery
Contributing editor

Ruth is passionate about helping people feel more confident about their finances. She was previously editor of Times Money Mentor, and prior to that was deputy Money editor at The Sunday Times. 

A multi-award winning journalist, Ruth started her career on a pensions magazine at the FT Group, and has also worked at Money Observer and Money Advice Service. 

Outside of work, she is a mum to two young children, a magistrate and an NHS volunteer.