With the Chancellor’s Budget billed for the end of November, the media is in peak ‘speculation mode’ about Rachel Reeves’ plans to raise taxes to meet the estimated £30 billion required to fund Labour’s policy commitments and rising government debt costs. Some articles published in newspapers read as if they were Rachel Reeves’s inner thoughts. In contrast, others appear to be policy stress testing designed to gauge public opinion on proposals.
Our general advice is not to make financial planning decisions on journalistic speculation, as there is a significant risk of causing financial detriment, which could affect your retirement plans.
However, as we have received several enquiries from clients asking whether they should or shouldn’t withdraw their Tax-Free cash, in this article, we thought it would be helpful to explore some of the main aspects of this topic to provide an informed but balanced view on the risk and consequences of taking Tax-Free cash now.
What are the current Tax-Free Cash rules?
Currently, most Defined Contribution (DC) pensions allow individuals to withdraw up to 25% of their pension as a Tax-Free lump sum, known as the Pension Commencement Lump Sum (PCLS). The maximum is currently £268,275 (25% of a pension fund worth £1,073,100), unless you have protected rights to a higher amount under older pension rules.
Once withdrawn, the remaining 75% of the pension is taxable when drawn, typically through income drawdown or the purchase of an annuity.
Who might this policy be targeted at?
Speculation about reducing Tax-Free cash tends to focus on higher-value pensions, as this is where potential revenue lies for a government trying to increase taxes.
- The average pension pot at retirement in the UK is around £60,000–£80,000 (Source: ONS), which would generate a Tax-Free cash sum of about £15,000–£20,000. While moving the fiscal needle would probably not be worth the political fallout for these individuals, for larger pension pots, it may well be. It would therefore seem that a cap on value would be a more targeted way of changing the rules surrounding Tax-Free cash.
- Those with pension savings exceeding £400,000–£500,000 are more likely to be the target of any policy change, and the Government is aware that those with higher pension savings are not typically the core Labour voters.
What is the speculation about changes to the Tax-Free Cash?
Despite calls for the government to rule out changes to the Tax-Free cash allowances, there has been no direct comment made on this to date. So far, we only have thought pieces from think tanks, such as the Institute for Fiscal Studies (IFS), which suggested that the Tax-Free lump sum could be capped at around £100,000 to raise additional revenue without increasing income tax or national insurance rates.
One of the more high-profile voices in this debate is Torsten Bell, former Chief Executive of the Resolution Foundation and now the UK Pensions Treasury Minister involved in the Chancellor’s Budget preparation. Bell has publicly described the Tax-Free cash regime as “very generous, very regressive, and a strange incentive not to stagger your retirement income.”
Bell’s direct involvement in advising the Chancellor adds weight to the speculation that pensions, including the Tax-Free lump sum, may receive scrutiny in the upcoming Budget. At the same time, he has emphasised fairness and political sensitivities, signalling that any change would likely be targeted at wealthier savers, rather than the average retiree.
In short, while no official policy has been announced, the combination of think-tank proposals and Bell’s influential position makes it clear that pension Tax-Free cash is on the radar of policymakers, creating uncertainty for savers.
Why Labour may not reduce the Tax-Free Cash Allowance?
While no official policy has been announced, we believe that the following factors reduce the likelihood of changes being announced in the upcoming budget:
- Recent Inheritance Tax Changes: The Chancellor has already significantly upended the pension rules by subjecting residual pension pots to Inheritance Tax. Any further changes would disrupt an industry trying to adapt to the most recent changes, which are the most significant shifts since George Osborne’s Pension Freedom Act in 2014.
- Mortgage Repayment: A cut to Tax-Free cash could limit retirees’ ability to pay down debt, which is one of the most common uses for Tax-Free cash, alongside boosting deposits and/or supplementing income in retirement.
- Retrospective legislation / Transitional Protection: Past changes to pension rules have mostly included protection for existing savers. Not including such measures at this budget would be a change of direction since Gordon Brown introduced the Lifetime allowance in 2006 and would further undermine the incentive to save for retirement.
- Limited Treasury Revenue: Even a full removal of the full 25% PCLS would not generate large sums relative to the national deficit. Still, the current estimate is that Tax-Free cash costs the government £5.5 billion annually, still relatively small in the context of the deficit.
- Savers’ Behaviour: Reducing tax incentives is likely to discourage pension saving, pushing future retirees to rely more on state support. This is especially true of the under-40s, who are already not saving enough into their pensions to support themselves in retirement. Further distrust in the pension system would undermine generational confidence in the effectiveness of pensions as a long-term savings contract for retirement.
- Inflationary Risks: If people rush to withdraw their Tax-Free cash before a deadline, it could temporarily boost consumer spending and therefore inflation. This depends on the level of Tax-Free cash released; however, those less financially literate or disciplined are more likely to use part or all to fund impulsive purchases, prioritising immediate gratification rather than long-term financial stability. This could lead to more inflationary pressures and the potential for interest rates to remain higher, which is costly for the government.
- Civil Service Pensions: Depending on the type of scheme, alterations to the level of Tax-Free Cash available could result in part of a civil servant’s lump sum that exceeds the new cap becoming taxable. This would mainly affect mid-to-senior grade civil servants with long service and would be unpopular unless Tax-Free cash protection was introduced. A certain saying about “Turkeys voting for Christmas” comes to mind.
- Political Risk: The government is likely to be very sensitive to policies that the public sees as a betrayal of trust and unfair, since its disastrous Winter Fuel Payment policy quickly turned politically toxic.
- Timing: The pension industry is slow to adapt; any change would require advance notice to ensure adequate time is provided to change the way they process Tax-Free cash. An “effective immediately” policy would create significant issues, such as updating IT systems and the treatment of applications in transit during the budget.
- Prior Chancellors have not made changes: whilst not a strong reason to think that this policy will not be introduced, pensions have been in focus before every budget in the last 30 years, therefore, there have been many opportunities for reform, but none have taken this path to date
Reasons You Might Consider Taking Your Tax-Free Cash
If you are considering withdrawing your Tax-Free cash, below are some of the reasons that it would be financially prudent to consider action:
- Inheritance Tax (IHT): Using Tax-Free cash to start lifetime gifts early could reduce IHT exposure if you survive seven years after gifting.
- Repaying Expensive Debt: Using Tax-Free cash to clear high-interest loans or mortgages can make financial sense.
- Investing in assets not permitted in pensions: Tax-Free cash can be used for home improvements to invest in assets not permitted in pensions, such as residential property or private companies.
- Funding ISAs or grandchildren’s JISAs: Tax-Free cash can be reinvested in other tax-efficient wrappers.
- School Fees Planning: Tax-Free cash for paying school fees in advance to avoid further increases.
It is important to appreciate that with all of the above options, should the pension member withdraw their Tax-Free cash and pass away before April 2027, they would have potentially created an Inheritance Tax (IHT) liability, as currently there is no IHT on inherited pensions.
Can You Change Your Mind?
You cannot reverse the decision once pension Tax-Free cash has been paid out. HMRC’s recent publication makes clear that the 30-day ‘cooling-off’ period offered by some pension providers does not apply to withdrawals that have already been made.
Once the funds have left your pension, the transaction is considered final and irrevocable – even if you later regret the decision. Attempting to reinvest the lump sum back into your pension could also fall foul of HMRC’s pension recycling rules, which are designed to prevent individuals from taking Tax-Free cash and reinvesting it to gain further tax relief.
Breaching these rules can lead to significant tax penalties, so anyone considering taking their Tax-Free cash speculatively should understand the implications before acting.
Advantages and Disadvantages
Below are some of the key pros and cons of taking your Tax-Free cash now:
Advantages
- Removes legislative risk that the current or future government could reduce or cap the allowance.
- Removes uncertainty and anxiety about “losing out” on a previously available allowance.
- It allows early IHT planning in advance of the changes coming into effect from 2027, such as starting a seven-year gift or investing the capital into IHT-exempt investments.
- For those over 75, Tax-Free cash is lost if not drawn before death. This would mean that cash that would have been transferred to a spouse Tax-Free would now become taxable at the spouse’s marginal rate.
- For those who have already reached the maximum lump sum allowance (£268,275 for most people), no further Tax-Free cash can be generated.
Disadvantages
- You lose the benefit of a tax wrapper, which allows Tax-Free investment growth and moves the capital into a taxable environment if invested, unless covered by the ISA allowance. This could lead to higher levels of income, dividends and capital gains tax.
- Future governments could change the rules in a way that later favours keeping the funds within the pension.
- The inability to change your mind if Rachel Reeves does not implement changes to the Tax-Free Cash rules.
- Cash and investments are assessable to means-tested benefits. Before state pension age, pensions are only assessable if income is being withdrawn from them (from state pension age, an assumed income applies if greater than the amount actually being withdrawn). This is especially relevant when considering care costs.
- Transitional arrangements or the delayed introduction of any reform might protect existing rights, making an early withdrawal unnecessary.
- If death occurs before April 2027 and a suitable nomination form has been submitted, it could be that those who have taken their Tax-Free cash will have lost the opportunity to leave their remaining pension fund without IHT. For married couples, there is no IHT on pensions transferred between spouses, and therefore, this date is not as relevant.
Summary
While it’s impossible to predict what the Chancellor will announce, history suggests governments are wary of breaking any form of ‘savings contract’ with the public.
We believe that the likelihood of a change to Tax-Free cash remains low; however, your decision to take your Tax-Free cash remains highly personal and needs to balance legislative risk, tax efficiency, and lifestyle priorities. What’s right for one saver may not be right for another.
As always, seek professional financial advice before making irreversible decisions about your pension.
If you would like to discuss the implications for your own portfolio, please do get in touch.