Could Reeves limit pension tax-free cash to £100k? Experts warn retirees against pre-Budget rush

Chancellor Rachel Reeves should consider reducing the amount of tax-free cash pensioners can take at retirement to £100,000, a Labour-aligned group, of which she is a member, has said.

Most retirees can take 25% of their pension pot tax-free from age 55. But there is a limit – £268,275. The reform would mean cutting the maximum amount they can withdraw from their pensions free of any tax by two-thirds.

Pension tax rules are currently “too generous and clearly unfair”, the Fabian Society report which put forward the proposal said. Reforms are needed “to address the systematic under-taxing of pensions”, it added, including tax relief.

MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

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.

A potential alternative would be for the chancellor to proceed gradually, reducing the maximum tax-free amount in steady slices of £20,000 or £30,000 at a time, Harrop suggested, with transitional protections for people near their pension age.

MoneyWeek has contacted the Treasury asking for comment.

Over-55s have already started making a dash for their tax-free cash. However pension experts are warning retirees not to rush in then regret their decision later – or worse face a 55% tax charge for breaching pension ‘recycling’ rules.

Helen Morrissey, head of retirement analysis at Hargreaves Lansdown, said: “Rumours around tax-free cash continue to swirl with concerns it may prompt people to take the money before the Budget happens.

“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.