Will Labour axe the 25% pension tax-free cash?

The Labour government is gearing up to launch a pension review, as announced in its party manifesto.

Chancellor Rachel Reeves could reveal the scope of the review in the autumn Budget on 30 October.

Pensions are an easy target for governments to tinker with and raise much-needed cash. The lifetime allowance, annual allowance and even the state pension triple lock have been chopped and changed over the past few years in a bid to save money.

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Reeves said yesterday that "difficult decisions" would have to be made as she announced that Labour had inherited a projected overspend of £22 billion from the Conservatives.

In the run-up to the election, the Labour party was accused by the Conservatives of planning to introduce a retirement tax.

This was a tax on the state pension - but in reality, Labour never announced anything like this. 

However, it’s highly likely we’ll see some other changes ushered in as part of the pension review, which could affect the way we save for retirement, and the tax rules we need to abide by.

Emma Reynolds, the new pensions minister, will no doubt be getting to grips with how the pension regime can be simplified and how to encourage more people to save for retirement - but in a cost-effective way.

One popular perk of the current pension regime is the 25% tax-free cash that most savers can enjoy when they start drawing their pension.

If a government was looking to raise revenue, it could reduce this to say 20%, or even axe it completely. Alternatively, ministers could set a limit on the amount of tax-free cash that can be taken. There is already a maximum of £268,275, but this could be cut in future.

Ian Price, a pensions expert and director of Price Consultancy, tells MoneyWeek that he is aware “that some individuals have taken their tax-free cash just in case something should happen”.

We look at whether the government is likely to tinker with tax-free cash.

Could Labour change the pension tax-free cash?

Tax-free cash - or pension commencement lump sum in the official jargon - is one of the most popular aspects of the pension system and a key reason why saving within a pension is advantageous from a tax point of view.

While pension savings are normally subject to income tax when withdrawn, a quarter of the pot can usually be taken tax-free.

During the election campaign, Sir Keir Starmer was asked about the future of tax-free cash and he replied that the current system would be reviewed in the coming years, were he to win the election. 

However, Labour spokespeople then said he had spoken in error, and that the tax-free lump sum was here to stay.

Having said that, there have been no assurances since Labour got into power, and a pension review, by its nature, could look at all sorts of things in terms of “improving outcomes for savers”. 

Changing tax-free cash would raise funds that could be used for encouraging, say, low earners to put more money away for their golden years.

Becky O'Connor, director of public affairs at PensionBee, comments: “The tax-free lump sum element to pensions is popular and one of the most universally well-understood benefits of a pension. Because of its popularity, making it less generous would be a risk.

“Options might be to change the percentage from 25% to say, 20%, or to change the maximum, which has been fixed at the same level despite the lifetime allowance being abolished and so now seems quite arbitrary.”

Price agrees that slashing or axing tax-free cash would be risky, saying: “I think it would be a very brave government that would reduce the tax-free cash on pensions.”

Could the maximum tax-free cash limit be lowered?

While the 25% tax-free cash could be maintained, the government could choose to reduce the maximum tax-free amount (£268,275) that savers can take.

O’Connor notes: “While the new government has not said anything overt about specific changes to this limit, it will no doubt be looking at every possible move to be made across all tax allowances to see if there is room for manoeuvre, with minimal political cost. 

“A small cut to the maximum, say to £250,000, would not technically affect most people, who do not have enough in their pension to be impacted, and could be justified on the basis that the current limit is not a good round number.”

On the flipside, O’Connor argues that Reeves, Reynolds and their colleagues in the Treasury and Department for Work and Pensions should be looking at increasing the maximum, not reducing it.

“Given the increase in pension pot values over time, a cut wouldn’t look good. An increase to the current level, say to £300,000, would certainly go down well with those worried about hitting the existing limit and would also make it more in line with where it ‘should’ be, given current and future increases in pension values,” she tells MoneyWeek.

Will Labour reintroduce the lifetime allowance?

When former chancellor Jeremy Hunt scrapped the lifetime allowance on pensions, Labour was quick to announce that it would reintroduce it if it won the general election.

However, the party then backtracked on these plans. As a reminder, the lifetime allowance is a cap on how much savers can stash in their pension pot before they are subject to tax of up to 55%.

But could the government reintroduce it? There was no mention of the lifetime allowance in the manifesto, suggesting Labour may be trying to keep its options open.

“It seems unlikely that with the lifetime allowance now abolished and this complicated piece of pension tax legislation now dispensed with, Labour would reintroduce it, with all of the difficulties that would entail,” says O’Connor.

She adds that it’s more likely that Labour’s pension review “will look to target pension funds themselves, and orchestrate a way to get a set percentage of pension funds invested in UK growth industries, before turning to pension tax benefits and allowances as a revenue raiser”.