Investment - Articles - Threat of Budget tax raid on pensions

 After something of a summer lull, speculation around the Budget erupted recently. First came the bruising forecast from the NIESR that the Chancellor could face a deficit in the public finances as great as £51billion.

 Then came a leak suggesting Treasury officials are looking at clamping down on the gifting regime to make it more difficult to reduce inheritance tax bills. The debate over what tax rises we could see in the autumn, if spending is not to be drastically cut, is now truly underway.

 Gary Smith, senior financial planning partner and retirement specialist at wealth management firm Evelyn Partners, comments: ‘If the NIESR’s estimate is in the right ballpark then the Chancellor will need to look at some big levers like extending the freeze on personal tax thresholds and maybe defrosting fuel duty. Tinkering with IHT reliefs is unlikely to make much of a dent in a £51billion black hole, certainly not in the short term. However, flying slightly under the radar at the moment is a potentially lucrative area for Treasury reform: the tax treatment of pensions. Suspicions last summer that the Chancellor was set at the 2024 Budget to cut the maximum tax-free pension cash down from the current £268,275 sparked a rush of enquiries from concerned clients, and our financial planners are experiencing something similar this summer.

 ‘Before the last Budget a significant number of savers above 55 years of age decided to take their tax-free lump sum. Some of those who had done so without a clear need or purpose for it scrambled in the days after the Budget to reverse their decision, with mixed results. In an echo of many recent Budgets, pension tax relief could come under the spotlight yet again, with recent HM Revenue and Customs figures showing very substantial amounts of income tax and National Insurance “sacrificed” by the Treasury as it allows savers effectively to keep their gross income if they put it into a pension. We can expect a rerun of last summer’s uncertainty, unless the Treasury rules out such moves. That it hasn’t, again - despite calls from stakeholders in the financial services sector to do so - can only leave people to suspect that pensions are on the table for the Budget.

 ‘Finally, it’s worth pointing out that any serious moves to curtail the preferential tax treatment of pensions threaten an outcry from public sector employees and schemes. The withdrawal of the Lifetime Allowance and the increase to the Annual Allowance under the last Government were in large part driven by demands from senior consultants and other highly paid public sector staff. A move to curtail the higher rates of pension tax relief would run into even more widespread public sector opposition. As always we would encourage anyone thinking of shifting significant sums around to take regulated financial advice.’

 Here Gary looks at some of the potential Budget moves around pensions and what savers and retirees, and the Chancellor, need to consider.

 The tax-free lump sum (take it or leave it?)

 Smith says: ‘The 25% tax-free cash has been the most treasured benefit of pensions for a long time, and even more so since pension freedoms allowed it to be taken as a lump sum while leaving the rest of the pension pot invested. It’s a bonus that keeps many people saving into their pensions.

 ‘The “tax-free lump sum” can be a slightly misleading term, as the tax-free element of one’s pension need not be taken as a lump sum but can alternatively be taken in a number of segments – alongside none-tax-free cash - over the years. For some savers this might actually be preferable taxwise and this could be a reason to pause before taking the 25% lump sum. However, taking the tax-free cash as a lump sum when a pension is first accessed is hugely popular and many savers have a purpose in mind for it, such as paying off the mortgage. This explains the rush by some savers to grab it before the last Budget.’

 Evelyn Partner’s DIY investor platform Bestinvest reported that the number of pension withdrawal requests from SIPPs more than doubled in September 2024, before the last Budget, compared to the same month in 2023. Most of these were from individuals accessing their tax-free cash.

 Smith adds: ‘A reduction in tax-free cash would put a big dent in pension freedoms and to many savers in the accumulation phase or nearing retirement it will feel like the goalposts have been moved as they’re halfway down the pitch. It seems more likely that the cap would be reduced than the percentage, and £100,000 was rumoured before the last Budget, after it was floated by the IFS. The current maximum of £268,275 means that those who amass a pot of £1,073,100 (the old Lifetime Allowance) will be getting less tax benefit from making further pension saving. But a reduction to £100,000 would bring that threshold down to just £400,000 and might discourage some individuals from saving more than that.

 ‘The suspicion that the pension commencement lump sum (PCLS) could be grabbed back in some way by the Treasury is a reason often cited for people giving up on pension saving after a certain point. The Pensions and Lifetime Savings Association (PLSA) estimates a pot of between £540,000 and £800,000 is necessary for a single person living outside London to have a comfortable retirement - and we would err towards the upper end of that range - while estimates for the average DC pension pot at retirement vary between £70,000 and £150,000. So tinkering with tax-free cash could weaken private saving at a time when state pension provision is coming under the spotlight as being unsustainable in the long term. However, there are three important aspects of this issue to keep in mind.

 ‘One is that tax-free cash has been capped in the past when the Lifetime Allowance was introduced and then reduced in subsequent years. Each time there were transitional arrangements put into place in the form of protected tax-free lump sums that savers could apply for at existing levels. While the Lifetime Allowance no longer exists, there is a good chance that any move to further limit the PCLS could be accompanied by transitional arrangements in order to lessen the impact for those close to retirement. After all, for many savers, the 25% tax free lump sum is a key benefit that they were banking on, perhaps to pay off the mortgage so that monthly loan payments will not eat into their pension, so slashing it without warning could throw retirement plans into disarray.

 ‘Second is the complicating factor of the inheritance tax rule change arriving in April 2027. The announcement at the last Budget that unspent pension assets will be subject to IHT from this date has sent many families back to the drawing board on how and when to use their pensions. Broadly speaking the change is driving retirees to think about drawing down on their pensions more rapidly, to gift or spend, or in some cases reinvest in offshore bonds. This is especially the case where savers will be older than 75 by April 2027, in which case the unspent pension assets could also be subject to income tax as the beneficiary draws on them – leading to a punitive 67% tax rate in some cases.

 ‘However, savers still need to be careful with taking their tax-free cash and with how they then use it – after all they are taking funds from a tax-protected wrapper, and potentially making them subject to capital gains, dividend or savings interest taxation. While it is not pleasant to think about, if someone withdraws their tax free cash now – when it is still exempt from IHT - and then dies before April 2027, they will have taken their funds from an IHT-free environment to a taxable one, as the money will enter their estate for IHT purposes, even if they gift it. Those who want to take their tax-free cash and gift it will still be subject to the seven-year rule. It is difficult to use the “normal expenditure from excess income” relief with a lump sum: you can’t take all your tax-free cash, stick it in a bank account and gift it gradually from there, as then it will be seen as a gift from capital and not from income.

 ‘Third, restricting the PCLS would not bring in extra revenue for the Government swiftly, it would be a long-term gain, so that could make this a less attractive move for Rachel Reeves, given how unpopular it would be. In conclusion, the same rule of thumb applies as did last summer: if you have a clear purpose for your tax-free cash and were thinking of taking it shortly anyway, then – if you believe there is a chance of it being restricted - there might not be much harm in accelerating that step by a year or two, but we would always recommend taking advice before extracting large sums. However, as the land lies at the moment, there aren’t enough firm signals that tax-free cash will be limited suddenly to justify the vast majority of people changing their financial plans.’

 Higher and additional rate pension tax relief – grab it while you can?

 HMRC this month revealed that gross pension Income Tax and National Insurance pension reliefs in the 2023/24 tax year is estimated to be £78.2billion, up from £72.1 billion in 2022/23. Of that, £54.2billion was Income Tax relief, a jump compared to £47.8billion in the previous year. Of the £54.2billion, 68% consisted of higher or additional rate tax relief.

 Smith says: ‘With the autumn Budget on the horizon and the public finances in a parlous state, you can’t help thinking that this data was noticed in the Treasury - particularly as, with the lion’s share of tax relief going to higher and additional rate taxpayers, there might be an equity argument for reform. Tax relief at the two higher rates could just be cancelled, leaving a flat rate of 20% relief for everyone.’

 The IFS has said that ‘limiting up-front relief to the basic rate of income tax would be a £15 billion a year tax rise, the vast majority of which would come from those who are in the top fifth of earners when making pension contributions’.

 Smith says: ‘While this step would provide the greatest saving for the Treasury, and would be the cheapest to administrate, it would cause uproar among higher paid public sector employees – unless there was a controversial carve-out for the public sector – and do nothing to encourage pension saving among basic rate taxpayers. Indeed, the likelihood is that it would damage pension saving overall. So, it is thought that if the Chancellor were to target pension tax relief, then a flat rate at a probable 30%, which could be sold as handing a bonus to basic-rate taxpayers in order to encourage saving, is favourite. However, it is still fraught with difficulties.

 ‘It would be relatively easy to implement in private sector relief-at-source pension systems where higher and additional rate taxpayers currently have to claim back their extra tax relief, as the basic rate of relief could be set at 30%. But increasingly popular salary sacrifice schemes would probably have to be stopped altogether as through these higher or additional rate taxpayers receive their 40% or 45% tax relief automatically by reducing their salary. However, the big issue is the net pay arrangements which exist in the public sector, as the upshot here is that – without a massive restructuring of the system - higher and additional rate taxpayers would essentially have to suffer a tax charge to claw back their higher and additional rate relief. The value of employer contribution that should be assigned to each individual employee is not straightforward to measure.

 ‘This would create huge opposition among the schemes and higher paid public sector staff, which could only be avoided by a public sector carve-out. That would in turn be very controversial by cementing what is already widely regarded as two tiers of pension provision in the UK. And it’s not a small issue as HMRC estimates that almost half (46%) of all up-front income tax relief is attributable to defined benefit schemes.

 ‘Separately, withdrawing higher rates of pension tax relief could dent faith in the private pension system and potentially hit savings rates at the very time that a Pensions Commission has been instructed to figure out how to get people saving more. The IFS rightly says that: “restricting relief on contributions while leaving the taxation of pension income unchanged clearly would be unfair on those (few) who are higher-rate taxpayers both while in work and in retirement: they would in effect be taxed twice on the same income, creating a large penalty for saving in a pension”.

 ‘It could also be seen among younger cohorts as yet another example of generational unfairness, with a key plank of private pensions that has benefitted those currently middle-aged and older being withdrawn from them. Finally, it would extinguish a crucial incentive remaining in an income tax system where millions are being drawn into ever-higher tax brackets. Fiscal drag means more earners are paying more in tax and facing unappealing steps in the marginal tax rate - at the higher rate threshold, the £100,000 mark where the personal allowance starts to be taken away, and the additional rate threshold which has enveloped hundreds of thousands of people since it was cut.

 'For millions, this “taxation by stealth” is alleviated by the knowledge that by contributing more to pensions they can at least keep more of their hard-earned pay. For others, the option of salary sacrifice means they can strive for that promotion or bonus without feeling that the majority of the reward is going to the Treasury as they get dragged into a higher marginal tax rate. Take that away and the danger is that motivation and aspiration are even further eroded, dragging on productivity and growth at exactly the time when these are key objectives of the Government.

 ‘Many earners will feel they are already at their limit in terms of how much they are contributing to their pension, and there is no point in being overambitious with saving and leaving yourself short of funds every month. But now is perhaps a good time for higher and and additional rate taxpayers to consider whether they are taking full advantage of this generous pensions perk.’

 Will salary sacrifice be sacrificed?

 Under this system, the employee’s salary is reduced by a certain amount, which is paid as an employer contribution into their pension. It can be advantageous in that relief is gained automatically against all income tax at all rates, as well as against National Insurance. Further, because the employer doesn’t pay NI on the salary sacrificed, they will usually pass on some or all of this saving by contributing an extra amount into the employee’s pension.

 Smith says: ‘As noted, banishing the higher rates of pension tax relief or creating a flat rate at 30% would probably spell the end for salary sacrifice pension arrangements. However, some HMRC-commissioned research published in May this year suggested that salary sacrifice across the board could well be in the Treasury’s spotlight, whether pension tax relief is reformed or not. Although higher and additional rate taxpayers get more income tax relief in salary sacrifice, basic rate taxpayers get a higher proportion of NI relief. At 8% on earnings in the basic-rate band, NI tends to make up a higher proportion of basic-rate taxpayers’ overall tax liability, with the extra NI paid by higher rate taxpayers just 2%.

 ‘Making pension contributions via salary or bonus sacrifice is a popular option for those whose earnings might fall into the 60% tax trap, a zone between £100k and £125,140 where the combination of high-rate tax and a tapered reduction in their tax-free personal allowance leads to a highly punitive effective income tax rate of 60%, which for many families is aggravated by the withdrawal of child-care benefits. The fault here lies with an unfairly structured income tax and benefits system that penalises people in this cohort disproportionately for increasing their earnings. Removing a legitimate mitigation strategy - increasing pension contributions via salary sacrifice - would seem harsh without reforming the real problem.

 ‘Many other popular benefits are accessed via salary sacrifice – such as childcare, technology, bicycles and even electric vehicles – and cancelling this would inevitably be very unpopular at a time when the cost of living is putting huge pressure on families at a number of income levels. After the Chancellor’s 2024 Budget statement, when she announced an increase to employers’ National Insurance from April 2025, salary sacrifice arrangements for workplace pension schemes became more attractive for many employers, because of potential NI savings. If these schemes were to be clamped down on, employers who have introduced or started to roll out the system will have to put their plans into reverse.’

 Annual Allowance – a reversal?

 Smith says: ‘With the difficulties around reforming the rates of pension tax relief in mind, it’s not unthinkable that the Chancellor’s gaze rests once more on the Annual Allowance, as this is a relatively straightforward way to control the amount the Treasury sacrifices in tax revenue via pension reliefs.’

 At the 2023 spring Budget, amid complaints from NHS executives that doctors, consultants and other senior staff were retiring early or cutting hours due to the tax penalties associated with extra pension payments, the Tory Chancellor Jeremy Hunt rather unexpectedly removed the Lifetime Allowance and increased the Annual Allowance from £40,000 to £60,000.

 Smith says: ‘It seems unlikely that the Lifetime Allowance will be resurrected, but if the Chancellor can figure out a way of keep well-paid NHS practitioners happy, then a cut to the Annual Allowance is a possibility. It could be taken back below the £40,000 level where it stood before April 2023, and still not hit the vast majority of people who pay nowhere these amounts into their pension each year. Even someone who is paying a gross £1,000 into their salary every month is still using only £12,000 of their £60,000 allowance.

 ‘The AA is not "use-it-or-lose-it" in quite the same way as the ISA allowance, as the option to use up to three previous years of unused allowances does exist under "carry forward" rules. While this process can be a bit complicated, it could be something of a “get-out clause” for those taken unawares by a reduction of the AA at the Budget. But again, perhaps now is a good time for many savers to review their pension forecast, and their contribution rates, ideally with the help of some expert advice.’