The tax-free pension lump sum has its problems, but is limiting the allowance actually a good idea, asks Daniel Herring
In order to plug the holes in her upcoming Budget, Rachel Reeves is reportedly planning a fresh tax raid, this time on the tax-free pension lump sum.
At the moment, anyone over 55 can withdraw a quarter of their pension pot tax-free, up to a maximum £268,000. The Chancellor apparently wants to limit this to just £40,000.
How does the tax-free lump sum work?
The tax-free lump sum is a funny quirk of our pensions system. In general, you get tax relief on the money paid into a pension pot, but pay tax as you withdraw it. In other words, your income is still taxed, just at a later point in your life. The tax-free lump sum, however, means that a portion of your pension escapes the taxman – acting not just as a pleasant way to start your retirement, but an incentive to save in the first place.
Purist economists would say that, strictly speaking, the lump sum does not comply with good principles of taxation. It benefits those with bigger pension pots most, and does little to help ensure pension adequacy for low- and middle-income earners. It might also encourage early withdrawal by savers, who would then find themselves running out of money later in their retirement.
So if you were designing a system from scratch, you might not include the tax-free lump sum at all. But that still doesn’t make Reeves’s reported plan a good idea.
Problems with Reeves’s plan
First, as happened when the same changes were floated last year, the uncertainty may cause people to rush to withdraw large amounts of their pension when they otherwise wouldn’t. This would undermine their income in retirement.
Second, it’s unfair. People rely on the lump sum. It forms a key part of any retirement strategy. Indeed, many people – particularly those close to retirement age – will have made contributions to their pensions precisely so that they could use the tax-free lump sum in early retirement, perhaps to pay off their mortgage. A change at short notice would punish them for doing the right thing.
Third, it risks undermining trust in the whole pensions system. If the government suddenly raids your pension pot with this change, what’s to say it won’t do so again in the future? It’s already made any money that’s left over taxable if you leave it to your heirs. Perhaps it will reduce the tax-free lump sum to zero. Or reverse Jeremy Hunt’s increases to savings allowances, making more of your savings taxable.
Pensions need predictability
Pensions, more than most other areas of policy, need to be free from politics and tinkering. The state is asking people to lock away their money for decades. People need to trust that they will be able to access it again without having been ripped off along the line – essentially being punished for being financially prudent and doing what they were told to.
The UK already has a big problem with the amounts people are saving for retirement. As Gordon Brown proved with his own pensions raids, arbitrary changes to raise a few billion in the short term can do a massive amount of long-term damage, deterring people from saving at a time when they already aren’t saving enough. Indeed, the Chancellor has made a huge song and dance about the need for pension funds to invest more in Britain. But if she wants those funds to increase investment, it’s downright foolish to reduce the returns for those paying into them.
The fact we are discussing this tax change – along with a whole range of other kites that are being flown, many involving taxing the possession or sale of a family home – shows a Chancellor with no desire, or ability, to articulate a long-term vision for the tax system. Instead, she has unleashed feverish speculation about what awful, punitive tax changes she will implement to meet short-term fiscal objectives.
If Reeves wants to make a principled case for removing the tax-free lump sum, then she should do so – for example by wrapping it into the government’s review of pensions and pension ages. But hasty changes will cause long-term economic damage, upset pensioners already smarting from the winter fuel debacle and, most concerning for her, do perilously little to balance the books.
Daniel Herring is head of economic and fiscal policy at the Centre for Policy Studies