Reeves ‘won’t target tax-free pension cash’ – but damage already done for some savers

Chancellor Rachel Reeves is no longer considering cutting the amount of tax-free cash retirees can take from their pension pots, according to reports.

Speculation that pension tax-free cash would be a target in the Budget has been swirling for some months. The Treasury had refused to be drawn on the issue, leaving pension savers nearing retirement worried they may miss out if they didn’t withdraw their 25% before the chancellor stands at the dispatch box on 26 November.

It was thought Reeves had been considering reducing the amount of tax-free cash pensioners can take at retirement to £100,000, following a recommendation by a Labour-aligned group, of which she is a member.

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But the chancellor is now no longer entertaining the idea of further limiting the level of tax-free cash retirees can take from their pension, according to a report in the Telegraph citing confirmation from unnamed officials. Moneyweek has contacted the Treasury for comment.

Jamie Jenkins, director of policy at Royal London said: "Royal London has been among many across the industry calling for clarity on tax-free cash, so this is good news. This is undoubtedly one of the most popular and best understood features of pensions, and it was becoming a great source of anxiety among savers."

Most retirees can take 25% of their pension pot tax-free from age 55. But there is a limit – £268,275.

Pension tax rules have been described as currently “too generous and clearly unfair”, in a Fabian Society report which put forward the proposal to lower the limit on pension tax-free cash to £100,000. It said reforms are needed “to address the systematic under-taxing of pensions”, including tax relief.

Cutting tax-free pension cash is a “progressive” policy “that would raise revenue from wealthy older people who have pensions that were historically under-taxed”, the report said.

But its author Andrew Harrop, a former Fabian Society general secretary, admitted the move was unlikely to appear in the Budget due to pushback from critics.

“The chancellor knows the media backlash she could expect. Rich savers nearing retirement would argue that their big untaxed lump sum was part of the pension ‘deal’ on which they had based their plans,” the report said.

Pension tax-free cash withdrawals surged 61% last year in a Budget-related frenzy as over-55s started making a dash for their tax-free cash. However pension experts have been warning retirees not to rush in this time around only to regret their decision later, with wealth firm AJ Bell calculating a retiree could miss out on more than £63,000 in investment returns by taking the tax-free cash too soon. Worse still you could face a 55% tax charge for breaching pension ‘recycling’ rules.

Helen Morrissey, head of retirement analysis at Hargreaves Lansdown, said: “People may rush to take the money now in the belief that they can reinvest it back into their pension if the change does not happen. However, they risk falling foul of pension recycling rules that will land them with a nasty tax charge.”

What are pension recycling rules?

Some people will have a plan for their tax-free cash – for instance to pay off a mortgage or carry out home renovations. But there will be others who are taking it as a knee-jerk reaction to Budget speculation, and this comes with risks.

HMRC recently clarified that people would not be able to put in a request for their tax-free cash and then cancel it should an announcement not be made in the Budget.

Some people may think they can take the tax-free cash now and then if the change doesn’t happen, just reinvest it back into their pension.

“However, doing this could put you at risk of breaching pension recycling rules which could see you clobbered with a hefty fine of up to 55%,” said Morrissey.

Pension recycling is deemed to have happened when someone has taken their tax-free cash and recycled it into their pension for the purposes of receiving artificially high tax relief.

For pension recycling to have happened, all of the following conditions need to have been met:

• The individual receives tax-free cash from their pension.
• Because of this, the amount of contributions paid into the pension scheme is significantly greater than it otherwise would be. HMRC will look at contributions in the tax year the tax-free cash is taken and the two tax years either side to determine this.
• The additional contributions are made by the individual or by someone else, such as an employer.
• The recycling was pre-planned. This is something that HMRC needs to establish, and it can prove very tricky. This planning must have happened either before or at the time the tax-free cash was taken, not after.
• The amount of tax-free cash, taken together with any other such lump sums taken in the previous 12-month period, exceeds £7,500.
• The cumulative amount of the additional contributions exceeds 30% of the tax-free cash.

The pre-planning condition is the area that causes the most confusion, said Morrissey. “It has to be proven that you planned to use your tax-free cash either directly or indirectly to boost your pension contribution to get extra tax relief.”

An example here could be taking out a loan to pay the increased contribution and then using your tax-free cash to repay it. HMRC says that each case is to be decided on its own merits so it’s difficult to outline cases that would definitely result in HMRC saying pre-planning hadn’t taken place.

In theory people can continue funding their pension without needing to worry about falling foul of the recycling rules provided not all of the above conditions are met.

However, it’s extremely complex. “People should consider speaking to a financial adviser if they wish to continue contributing to their pension to make sure they don’t inadvertently break the rules,” said Morrissey.