Speculation that the Chancellor may reduce the amount of tax-free cash you can take out of your pension in the Budget continues to grow, with many worried that it could see their tax bills jump during retirement.
Under current rules, usually you can take a 25% tax-free lump sum from your defined contribution pension once you reach the age of 55, rising from 57 to 2028. The maximum tax-free lump sum you can take is linked to the previous Lifetime Allowance which was scrapped in April 2024. This means you can take out no more than £268,250 tax-free (25% of the old £1,073,100 Lifetime Allowance). If you have more than £1,073,000 in your pension, then the tax-free element you can take will be less than 25%. Learn more in our article How much tax-free cash can I take from my pension?
You don’t have to take the full 25% at once if you don’t want to. For example, you can take smaller regular amounts from your pension if you prefer, and 25% of these payments will be tax-free. So, for example, if you had a bigger pension pot and were to take £3,000 from it each month, £500 of this would be tax-free whilst the remaining £1,500 would be taxable. Find out more in our guide How much tax will I pay when I withdraw my pension?
Here we look at how changes to the tax-free lump sum could affect you, and explain how to get advice on your pension. Bear in mind that the examples shown below apply to defined contribution pensions, where any contributions made are invested, and the amount you end up depends on how much has been paid in and how your investments have performed.
If you’re considering seeking professional financial advice on the options available to you, we’ve partnered with nationwide independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial advisor. There’s no obligation, however if the adviser feels you’d benefit from paid financial advice, they’ll talk you through how that works and the charges involved.
Fidelius are rated 4.7 out of 5 from over 1,500 reviews on VouchedFor, the review site for financial advisors.
What could happen to the tax-free lump sum?
There are rumours that the Chancellor Rachel Reeves might cut the amount of tax-free cash people can withdraw from their pensions to as little as £100,000.
According to the Institute of Fiscal Studies (IFS), reducing the amount that can be taken tax-free by almost a third from £286,275 to £100,000 would affect about one-in-five retirees. It says that this change would raise around £2 billion a year in the long run for government coffers, with losses concentrated among the relatively wealthy.
Myron Jobson, Senior Personal Finance Analyst at interactive investor, said: “While the move would increase tax revenues as part of efforts to plug the multi-billion pound black hole in the public’s finances, it threatens to devastate many meticulously crafted retirement plans.
“Those approaching retirement who have already mentally allocated amounts above £100,000 for paying off their mortgage and/or repaying outstanding debts would be forced to go back to the drawing board and reallocate cash from elsewhere – or face a longer time burdened with repayments. The pension tax-free lump sum is one of the best-loved and most well-understood parts of the pension system. Significant changes to it could risk undermining confidence in pensions, which is the last thing we need as many people aren’t saving enough for a comfortable retirement.”
How cutting the tax-free lump sum could affect you
The effect any reduction in the tax-free lump sum will have on your pension will depend very much on your individual circumstances and the amount of retirement savings you have.
Financial services company Hargreaves Lansdown has looked at three different scenarios where the lump sum is cut from its current level of £268,275 to anywhere between £225,000 and £100,000 to show the potential impact on pension savers. Bear in mind that if you have protected allowances, the amount of tax-free lump sum you can take and your overall tax-free limit may be higher. Your entitlement amount depends on the particular protection that you hold. You can read more about how these work at GOV.UK.
Scenario 1
The tax-free lump sum is reduced to £225,000.
Who’ll be affected: Those with a pension pot of £900,000 or more without protections, aged 57 on or after 6 April 2024.
The immediate cost to those retiring will be income tax on up to £43,275 (£268,275 – £225,000), at a cost of £17,310 to a higher rate taxpayer or £8,655 to a basic rate taxpayer.
Scenario 2
The tax-free lump sum is reduced to £150,000.
Who’ll be affected: Those with a pension pot of £600,000 or more without protections, aged 57 on or after 6 April 2024.
The immediate cost to those retiring (with no protection) will be income tax on up to £118,275 (£268,275 – £150,000), at a cost of £47,310 if taxed at higher rates or £23,655 if taxed at the basic rate.
Scenario 3
The tax-free lump sum is reduced to £100,000.
Impact – Those with a pension pot of £400,000 or more without existing protections, aged 57.
The immediate cost to those retiring (with no protection) 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.
Helen Morrissey, head of retirement analysis at Hargreaves Lansdown, said: “The rumoured changes may sound like they will only hit the wealthiest, but this is not the case. If we look at someone with a £400,000 pension purchasing an annuity, it would generate an income of around half the median average wage in income (£34,953) of around £20,000 a year at age 67. If you wanted to hit this median level, you would need a pension pot of £469,000 after adding in the full State Pension. So, while this group may have enough income to meet their needs in retirement, they are hardly living a lavish lifestyle.”
Don’t make panic decisions
Recent weeks have seen countless pension savers rush to take money out of their pensions to take advantage of tax-free cash rules as they currently stand. However, this is not a decision to be taken lightly, nor without first seeking professional financial advice, as it can come with significant risks.
For example, you’ll be moving money from a tax-advantaged environment into one where growth and income are taxed, and this could potentially push the value of your estate over the current Inheritance Tax (IHT) threshold. (A pension typically sits outside of your estate for IHT purposes). It’s also worth noting that many of us will spend several decades in retirement, so taking out 25% of your pension early on might mean you end up running out of money too soon in retirement.
Michael Summersgill, chief executive at AJ Bell, said: “Rumours about the future of tax-free cash, one of the best understood and most valued benefits of pensions, are particularly problematic. Taking your tax-free cash is an irreversible decision and, assuming the Chancellor doesn’t pursue a disastrous raid on tax-free cash, those people may find they’re in a worse financial position long-term.”
If you’re considering seeking professional financial advice on the options available to you, we’ve partnered with nationwide independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial advisor. There’s no obligation, however if the adviser feels you’d benefit from paid financial advice, they’ll talk you through how that works and the charges involved.
Fidelius are rated 4.7 out of 5 from over 1,500 reviews on VouchedFor, the review site for financial advisors.
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