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Tax-free lump sum: “One of the few features of the pension tax system that people know and value,” says Steve Webb
Is there any advice you can offer to mitigate potential pension tax increases?
In particular, if the 25 percent tax exemption is eliminated, would you recommend starting to plan to utilize that 25 percent now?
If pension taxes change, how much notice will we receive for changes to be made?
SCROLL DOWN TO FIND OUT HOW TO ASK STEVE HIS PENSION ISSUE
Steve Webb answers: My inbox has been full this week with questions about possible changes the new Labour Government might make to the pension tax cut and state pensions.
To be honest, I would be quite surprised if the new government had already reached a conclusion on most of these issues, so any answer from me will inevitably be somewhat speculative.
But I hope to be able to point out some things the Government would have in mind when considering any changes, and also to set out what its options might be.
As you know, it is generally possible to receive 25 percent of a “money” pension in the form of a tax-free lump sum.
It is often also possible to receive tax-free cash as part of a traditional final salary pension plan.
In legislation, these are often referred to as “pension start lump sums” (PCLS), but for brevity I’ll just refer to them as “tax-free cash”.
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The ability to withdraw money from a pension tax-free is one of the few features of the pension tax system that people know and value. So it would be a brave politician to make significant changes to this part of the system.
During a radio programme during the election campaign, current Prime Minister Keir Starmer suggested there would be a change, but the Labour Party immediately admitted he had made an erroneous comment.
As far back as the 1980s, the late Nigel Lawson, the former Conservative Chancellor of the Exchequer, said he had considered changing the “much-loved but anomalous” tax-free lump sum but had decided against it.
Given that large numbers of people expect to receive tax-free cash from their pensions (including ten million people newly enrolled in workplace pensions since 2012), the political outcry if this entitlement were removed overnight would be enormous.
Therefore, I think total abolition is exceptionally unlikely.
Lifetime limit on tax-free pension money
However, there are ways to introduce more limited changes. The most obvious would be to look at the lifetime limit for tax-free cash. From April 2023, this has been set at the very precise figure of £268,275.
This is simply 25 per cent of the (now abolished) lifetime allowance of £1,073,100.
At the very least, I would expect this figure to freeze each year, meaning it will gradually affect more people over time.
But one possibility would be for a new Chancellor of the Exchequer to reduce the limit, perhaps to £200,000 or £150,000.
This would still be far above the tax-free money most people could dream of receiving in their lifetime, so the political cost could be quite low.
In any such change, a key question would be what “transitional” arrangements would be put in place for those who might be unfairly affected.
One possible transitional measure would be to say that those who were already going over the new limit based on pension savings they had already made could still get tax-free cash up to the old limit, but that no further entitlements to tax-free cash could be built up in this case.
It would be quite complicated to implement, but it would not be the first time a government has thought that complexity is a price worth paying for the additional revenue it could expect from limiting tax relief.
While I cannot offer you personalized advice on how you might respond to this possibility, I can say that it seems highly unlikely that such a change would be applied retrospectively.
To be more precise, if someone had already withdrawn tax-free cash in excess of the new (lower) limit, I would not expect to receive a retroactive tax bill.
I would also be surprised if there were any penalties for those who accessed their tax-free money after the election but before any government announcement.
But I want to stress that this is just my best estimate and you should seek independent financial advice before making any major decisions about your pensions.
However, it is possible (as I noted in my previous column on the Lifetime Benefit) that the Government could stand up and announce that, while any change to the limits would not take place until a future date, any lump sum entitlement accrued from now on would not qualify for any transitional protection.
This means that, although changes normally only take place at the beginning of a financial year, it is still possible that a Government announcement could kick off a change with more or less immediate effect.
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