Cap 25% pension tax-free lump sum at £100k, says IFS

The 25 per cent tax-free lump sum should be capped at £100,000 to help make savings perks fairer, an influential thinktank said today.

The controversial call came from the Institute for Fiscal Studies, which said a maxmimum pension pot size of £400,000 should be used for the tax-free lump sum – dramatically hacking back the amount savers can take.

The popular and well-known lump sum rule allows people to tap their pots for large amounts at the outset of retirement – it is often used to get shot of mortgages, fund big home improvements or pay for dream holidays.

But it provides a large tax subsidy to those with high incomes and big pensions and is of less or no value to people facing retirement on lower incomes, according to the new report by the Institute for Fiscal Studies.

Popular perk: Lump sum rule allows people to tap pots for large amounts at retirement

Capping the tax-free lump sum at, for example, £100,000 would only affect one in five of people approaching retirement, it says.

It could be accompanied by subsidies designed to be as generous as the existing system to basic-rate taxpayers, and to provide equivalent support to non-taxpayers – alongside a wider shake-up of tax breaks that the IFS says are ‘overly generous’ to those with the biggest pensions.

The proposal would be challenging to implement as many savers build their retirement finances around immediately accessing a 25 per cent tax free sum when they give up work, and a ‘cliff edge’ move would penalise younger generations.

It received immediate pushback from pension industry experts. One said it would be ‘deeply controversial and risk a backlash of biblical proportions from voters’, and another that it would have a chilling effect on pension saving.

The IFS report says the current system of pensions tax provides most benefit to those with the biggest pensions and high retirement incomes, and those receiving big employer pension contributions.

‘It does relatively little to support many of those facing low income in retirement, who most need it.

‘Reducing limits on pension saving – the route taken in recent years – is not a good solution: it does nothing to support low earners, adds significant complexity and leaves subsidies that are still too generous for some.’

The IFS says its proposals, published in a report funded by the abrdn Financial Fairness Trust, would support pension saving more evenly.

‘The reforms would boost the retirement incomes of the bottom 80 per cent of earners and provide greater encouragement for them to save more in a pension, while getting rid of overly generous subsidies that benefit those on high incomes.’

What would a shake-up of pension tax breaks involve?

The IFS report calls for the following wider package of reforms, in addition to changing the 25 per cent tax-free lump sum rule.

– Reform the lifetime allowance and end the tapering of the annual allowance

‘The lifetime and annual limits on the amount that can be saved free of income tax in a pension have been cut sharply since 2011.

‘This has created complexity and damaging disincentives for an increasing number of higher earners.

‘Since the other reforms we propose would get rid of the excessive generosity in the current system, they would allow policymakers to be more relaxed about these limits.’ Read more about how the lifetime allowance and annual allowance work below.

– Give upfront employee National Insurance contributions relief on all pension contributions, and tax pension income instead

‘While you get upfront income tax relief on pension savings, you do not get up-front relief from employee NICs on your own contributions.

‘We should gradually move to a system where all private pension income is subject to employee NICs. This would align the income tax and employee NICs systems and would benefit low and middle earners who make individual contributions, at the expense of higher earners enjoying big employer pension contributions.’

– Apply employer NICs to employer pension contributions

‘Employer pension contributions escape employer NICs entirely. This is a huge tax break but is of no value when employers are not liable for employer NICs – for example, small employers.’

What do pension experts say?

‘Capping the tax-free amount you can withdraw from your pension would be a serious disincentive to pension savers,’ says Alice Guy, personal finance spokesperson at Interactive Investor.

‘The 25 per cent tax free pension incentive is one of the best well known and best-loved pension rules.

‘Encouraging people to save more for retirement is a battle for hearts and minds and slashing one of the most popular pension benefits could have a chilling effect on pension saving.’

Jason Hollands, managing director of Evelyn Partners, says: ‘People need to be encouraged to make appropriate provision if they want to avoid facing a steep decline in the living standards they have been used to when retiring.

‘Our current system is certainly far from perfect, but regular tinkering has a corrosive effect on the savings impetus, giving the impression that the system is in flux.

‘This risks undermining confidence in private pension saving as people fear that the goal posts will just keep getting moved.”

‘A raid on the tax-free lump sum by capping it would be particularly unwelcome, especially by those who may have planned to use this for purposes like paying off a mortgage.

‘Were such a policy to be implemented relatively quickly, it could leave retirement plans in a very difficult place. .

Tom Selby, head of retirement policy at AJ Bell, says: ‘Some of the ideas put forward here, in particular capping pensions tax-free cash, would be deeply controversial and risk a backlash of biblical proportions from voters.

But he adds: ‘The pension tax reforms set out by the IFS are balanced and well thought through.

‘While often think-tanks will jump to radical proposals such as scrapping higher-rate pension tax relief in favour of a flat rate, the IFS rightly acknowledges this would create significant challenges, particularly for defined benefit schemes.’

This post first appeared on Dailymail.co.uk