Will Chancellor target 25% tax-free pension lump sums in the Budget?

A cap on pension tax-free lump sums is rumoured to be among the cash-raising measures the Chancellor is considering ahead of the Autumn Budget.

Withdrawing up to 25 per cent from your pension free of tax is a popular perk at retirement, and fears Rachel Reeves might tighten the rules were not realised last year.

But it is likely to appear on a long list of options being drawn up by Treasury officials, according to a report in the Daily Telegraph.

Last year, many people made withdrawals as a precautionary measure before the Budget, despite warnings they could miss out on investment growth under the tax protection of a pension in future.

Pension experts have issued similar alerts this week about making hasty moves if you don’t have a plan for what you would do with the money.

Savers typically use their lump sums to clear mortgages and other debts, and splash out on home renovations, new cars and holidays at retirement. 

Speculation is rife about the Budget right now – regarding inheritance tax, pension tax relief, and property tax, among other issues – which could prompt financial decisions that later backfire.

So, what do you need to know about tax-free lump sums, and what are the pitfalls of taking them unnecessarily.

Budget speculation: Last year many people made tax free cash withdrawals, while others piled in money in case pension tax relief was slashed – but then the rules didn’t change

How do tax-free lump sums work?

Many people nearing retirement age may have a mix of defined contribution and defined benefit pensions, and the rules differ for each type of scheme.

Defined contribution pensions: These take sums from both employers and employees and invest them to provide a pot of money at retirement.

Over-55s can take 25 per cent of their pension pot tax-free upfront, or opt to withdraw it gradually in chunks.

By not withdrawing the whole lump sum out at once, if your pot grows in future you will have more tax-free cash available to take in the longer run.

Defined benefit salary-related pensions: Final salary or career average defined benefit pensions provide a guaranteed income after retirement for the rest of your life.

Your options for a 25 per cent lump sum vary according to the generosity of the terms and conditions of your scheme, so you have to check the specific details.

If you have a large pension pot, there was an important change following the ditching of the lifetime allowance in April 2023 – the £1,073,100 total limit people could have in their pension pot without facing tax penalties.

The 25 per cent tax free lump sum was capped at £268,275 – a quarter of the old lifetime allowance limit.

However, if you have fixed protection relating to a previous, more generous lifetime allowance level your higher 25 per cent lump sum figure can apply, even if you start paying into your pension again.

Fixed protection is a complicated area and it is best to seek financial advice about it.

What to consider before taking your tax-free lump sum

– You do not need to take it all at once, or even at all, if you don’t have a good reason to spend it now.

– Think about whether you will need the money later if you are in good health and all being well could live a long time.

– If you are investing your pension and do so wisely, your pot could continue to grow and boost how much you have available to withdraw in tax-free chunks over the longer term.

– When you take anything over and above your 25 per cent lump sum from a defined contribution pension, from then onwards you can only contribute £10,000 a year and still get tax relief.

– If you take the lump sum and decide to reverse your decision, you may be able to cancel the instruction to your provider but this is not guaranteed – check the rules in advance.

– Be aware that if you reinvest the tax free cash back into your pension you might fall foul of recycling rules, which are aimed at preventing people trying to seek an advantage by getting extra tax relief.

What do pension experts say?

‘Rumours around tax-free cash have been rife, with speculation that the Chancellor may look to trim back how much you can take,’ says Helen Morrissey, head of retirement analysis at Hargreaves Lansdown.

‘Rumours are concerning, but they are just that – rumours, and it’s important you don’t feel pushed into taking a decision that you later come to regret.

‘We know from last year that there’s a risk speculation encourages people to take their tax-free cash earlier than they need to, and once it is removed, there are no guarantees it can go back in.’

Morrissey says a pension is a hugely tax efficient way to build wealth, and moving your money leaves you open to a host of taxes – such as capital gains or dividend tax – and you could miss out on investment growth.

That could give you a bigger pension, and more tax-free cash down the line, which would be more productive than keeping the money in an easy access cash account, she points out.

She warns: ‘Those who take the tax-free cash and hope to reinvest it back into their Sipp if the change is not made need to be incredibly careful. 

‘There’s every chance you could fall foul of strict pension recycling rules that could see you clobbered with a substantial tax charge.

‘Some thought they could make a late instruction to take tax-free cash in the run up to the last Budget and then cancel it if needed, only for HMRC to say they would be unable to do so. It’s a situation that can cause upset and distress.’

Gary Smith, senior financial planning partner at Evelyn Partners, says: ‘The 25 per cent tax-free cash has been the most treasured benefit of pensions for a long time, and even more so since pension freedoms allowed it to be taken as a lump sum while leaving the rest of the pension pot invested.

‘The ‘tax-free lump sum’ can be a slightly misleading term, as the tax-free element of one’s pension need not be taken as a lump sum but can alternatively be taken in a number of segments – alongside non-tax-free cash – over the years.

‘For some savers this might actually be preferable tax-wise and this could be a reason to pause before taking the 25 per cent lump sum.’

Smith says a reduction in tax-free cash would put a big dent in pension freedoms, and savers could feel like the goalposts have been moved as they’re halfway down the pitch.

‘For many savers, the 25 per cent tax free lump sum is a key benefit that they were banking on, perhaps to pay off the mortgage so that monthly loan payments will not eat into their pension, so slashing it without warning could throw retirement plans into disarray.’

He says the Government’s plan to levy inheritance tax on pensions from April 2027 is another complicating factor.

‘Broadly speaking the change is driving retirees to think about drawing down on their pensions more rapidly, to gift or spend, or in some cases reinvest in offshore bonds. 

‘This is especially the case where savers will be older than 75 by April 2027, in which case the unspent pension assets could also be subject to income tax as the beneficiary draws on them.’

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