This article is out-of-date. Please see our newer article on this topic: What is the 25% pension tax-free cash - and when should you take it?
The Labour government is rumoured to be considering slashing the maximum tax-free cash that pension savers can take from their pots.
The popular pensions perk allows savers to withdraw 25% of their nest eggs tax-free, up to a limit of £268,275.
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Chancellor Rachel Reeves could potentially make an announcement in the Autumn Budget on 30 October.
The Telegraph has reported that government officials have asked one of Britain’s top pension providers to assess the impact of cutting the tax-free lump sum to £100,000.
Both the Institute for Fiscal Studies (IFS) and the Fabian Society have argued that the allowance should be reduced to £100,000 because the current cap favours the wealthy.
There is also speculation that Labour could reduce the 25% tax-free cash amount to, say, 20%. And that the Budget could introduce a flat rate of pensions tax relief - but Reeves has reportedly shelved this idea.
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”.
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.
However, any move to slash the pension tax-free cash could be seen as another attack on pensioners after Rachel Reeves’s winter fuel payments raid.
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While pension savings are normally subject to income tax when withdrawn, a quarter of the pot can usually be taken tax-free.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 Starmer and Reeves have repeatedly warned that "difficult decisions" will have to be made, due to Labour inheriting a projected overspend of £22 billion from the Conservatives.
Becky O'Connor, director of public affairs at the pension provider 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 policy of taking a quarter of your pension tax-free may be maintained, the government could choose to reduce the maximum tax-free amount (£268,275) that savers can take.
The Telegraph suggests reducing the limit could raise around £2 billion in revenue at the Budget. Cutting the allowance to £100,000 could affect one in five retirees, according to the IFS.
Hargreaves Lansdown says those with a pension pot of £400,000 or more would be impacted, with savers facing a tax bill of up to £67,310.
Helen Morrissey, head of retirement analysis at the investment platform Hargreaves Lansdown, explains: "The immediate cost to those retiring will be income tax on up to £168,275 (£268,275 – £100,000), a cost of £67,310 if taxed at higher rates, or £33,655 if taxed at the basic rate."
She adds: “The chancellor may have said rumoured changes are designed to hit ‘those with the broadest shoulders’ but changes to the tax-free lump sum would do irreparable damage to the pension system. This risks undermining confidence and impacting people’s retirement savings."
Claire Trott, divisional director for retirement and holistic planning at the wealth manager St. James’s Place, warns that speculation around a reduction to the maximum tax-free cash allowance is "driving behaviours, which could result in people withdrawing excessive funds from pensions, potentially risking reduced retirement incomes".
She adds: "Moving money from a tax-privileged environment into one where growth and income are taxed, and potentially pushing estates into inheritance tax liability, can have significant implications".
Should I take my tax-free cash now just in case?
This is a risky strategy. No one knows exactly what Reeves will announce until she stands up and delivers her speech on 30 October.
While topping up your ISA could be a sensible move in the run-up to the Budget, as saving more is generally sound financial advice plus you can take the money out if you need it, experts caution against taking your tax-free cash purely to avoid a Labour tax grab.
This is because pensions offer a valuable tax shelter. If you take out your money, where will you put it? If you park it in a savings account or investment account, it will liable for tax.
In addition, under current rules, pension savings are usually free of inheritance tax – but this is not the case with money in ISAs, investment accounts or savings accounts so there’s the chance that taking your tax-free cash now could land your family with a nasty tax bill in future.
And don't think you can withdraw the cash "just in case" and then if nothing is announced at the Budget, pay it back into your pension.
There are rules in place to prevent savers taking out tax-free cash and then reinvesting in their pension (known as recycling). Those caught by recycling rules will be taxed at up to 55% of their tax-free cash amount.
We explore this further in Pension moves you should make before Labour’s Budget raid.
Will Labour reintroduce the lifetime allowance?
When former chancellor Jeremy Hunt scrapped the lifetime allowance on pensions, Labour was quick to announce that they would reintroduce it if they 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.
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