There has been plenty of speculation in the media recently that the next government will remove the tax free lump sum from pensions.
Readers of this blog will know that I am a pedant at heart, and feel the need to point out that the “tax free cash sum” was replaced by the “pension commencement lump sum” (PCLS) back in 2006, so the “tax free cash sum” has already been removed. But most people still refer to the tax free cash sum when talking about the PCLS. The name was changed because the PCLS isn’t always tax free.
At present, if you are 55 or over, you can withdraw a lump sum from most pensions of at least 25% of its value. There are some exceptions to this, but we have had enough pedantry for one blog post already.
What if the right to a tax free lump sum from your pension was removed? What would the impact be?
There would be a few immediate impacts. Under the heading of “stating the obvious”, you would have to pay tax on any lump sums you withdrew from your pension. If you had a pension fund of £500,000, the value of your lump sum would reduce. Depending on how much other taxable income you had in the tax year in question, if we assume that the lump sum of £125,000 was simply added to your other taxable income, some of it would suffer tax at an effective rate of 60%. That’s a significant increase; if your other earnings were £30,000, you would lose around £52,500 of the lump sum in tax in the example.
Faced with this extra tax charge, I suspect that many people would put off drawing a lump sum from their pension to a time when their income was lower, or could be manipulated to be lower. If you were able to have no taxable income for a tax year, you could reduce the tax on the lump sum in the example to £24,540. It’s not too difficult to have no taxable income, if you can live off non-taxable funds, like ISAs.
So, I suspect that one of the major changes would be an increase in tax planning activity, as people take action to minimise the amount of tax they pay. At a government level, this activity could reduce the extra tax revenue by a significant amount.
The removal of the tax free lump sum would almost certainly make people more wary of investing more money into pensions. After all, pensions are only made up of investments that have beneficial tax treatment. People would, therefore, be more likely to save in different ways for their retirements which don’t have the same tax breaks as pensions. As a result of the removal of this tax break, people would have to choose between having less money to spend when they are working (as they will have to save more for retirement), retiring later, or having a lower standard of living in retirement; there are no other realistic options.
One valid concern about the removal of the tax free lump sum is that people might seek riskier alternatives to mainstream, regulated investments. Scammers would probably be one of the first to react to such a change, no doubt promising ways of restoring your tax free lump sum as a way of them relieving you of some or all of your pension fund. I would hope that a government would anticipate this before making such a change, but I worry that I will be disappointed.
I’m not an economist, so I won’t speculate on how the economy might be affected by this change. However, it does seem reasonable to guess that the government will increase its tax take, whilst consumers will have less to spend in the economy.
The removal of the tax free lump sum has been a subject of speculation for as long as I have been a financial planner, and yet it has never happened. I still think that it’s unlikely, as there are other ways of raising tax from pensions, which would be more palatable to the public. However, both main parties have talked about reducing “tax avoidance” (this is legal) as well as “tax evasion” (illegal), and it is just about possible that the use of the tax free lump sum could be considered to be avoidance.
If you were to speculate and withdraw your own tax free lump sum now, but a future government did not actually withdraw your right to a lump sum, the tax consequences could be significant, as pensions remain one of the most tax-efficient investment vehicles available to you. Not only would you pay more tax on the returns achieved by the money that used to be in the pension, but the money would become part of your estate for inheritance tax purposes.
Our advice, as usual, is to take advice before acting!
Philip Wise | philip@sussexretirement.co.uk
Managing Director and Chartered Financial Planner
This blog is for information purposes and does not constitute financial advice, which should be based on your individual circumstances.
The value of investments may go down as well as up and you may get back less than you invest.
A pension is a long-term investment and the value is not guaranteed. Any advice or considerations are personal to each individual’s circumstances.
The Financial Conduct Authority does not regulate some aspects of Tax and Estate Planning.
