Retirement: Tax-free lump sums from pensions to be capped at £36,000?

A think-tank has called on the Government to make radical changes to the UK pension system.

Before every Budget and Autumn Statement rumours start to circulate that the Government of the day will cut the tax-free lump sum or reduce tax-relief on pensions. To date successive Chancellors have steered clear of these measures, preferring more convoluted approaches to reducing the cost of pensions.

However, in its ‘Tax-relief for pension savings in the UK’ report, the Pensions Policy Institute (PPI) has now proposed radical changes to both the tax-free lump sum and the level of tax-relief paid to pension savers.

The report was sponsored by a number of organisations including Age UK, the TUC, the Institute and Faculty of Actuaries, and Partnership, an Annuity provider.

Maximum tax-free lump sum from pensions

At present the maximum tax-free lump sum, also known as the Pension Commencement Lump Sum or PCLS, available from a Personal Pension or SIPP (Self-Invested Personal Pension), is generally 25% of the fund value.

However, the PPI has suggested that the tax free lump sum should be capped at £36,000, affecting anyone with pension savings in excess of £144,000.

Most would-be retirees take the maximum available lump sum, often using it to top up savings, meet capital expenditure, repay debt or create much needed additional income. In our experience very few spend it on luxury items and in most cases it simply helps to deliver a more financially comfortable retirement.

Most experts believe that any cap would be seen by most retirees, who have saved into pensions in the belief that a 25% tax-free lump sum will be available when they finish work, as a backward step.

Pension tax-relief proposals

Under the current system, contributions into a pension attract tax-relief. All contributions immediately benefit from basic rate tax-relief, effectively adding 20% to the value of the payment, whilst higher rate tax payers can claim an additional 20% or 25% via the self-assessment system.

However, the Government has already effectively capped the level of tax-relief available by reducing the maximum contribution which will attract relief to £50,000 in the current tax year and £40,000 in 2014/15.

But with the annual cost of tax-breaks for pension savers topping the £35 billion mark, it is clear the Government needs to find savings and the report from the PPI has recommended the current tax-relief system should be replaced with a flat rate of 30% paid.

If implemented the proposals would be cost neutral for the government, but would increase the amount of tax-relief for less well off pension savers, whilst higher earners, to whom the majority of tax-relief currently goes, would lose out.

Chris Curry, Director of the PPI said: “The current system of pension tax relief favours higher and additional rate taxpayers. Even with pension saving boosted for lower earners by automatic enrolment, basic rate taxpayers are estimated to make 50% of pension contributions, but receive only 30% of pension tax relief on contributions.”

Curry continued: “Pension tax relief on lump sums, at an estimated cost of £4bn a year, is similarly uneven. While only 2% of lump sums are worth £150,000 or more, they attract almost one-third of tax relief on lump sums. “

“While recent reforms have reduced the cost of tax relief, they have not increased the value of saving for any individuals. More radical alternatives, such as a single rate of tax relief applied to all pension contributions, could spread the advantages of tax relief more evenly.

A tax relief rate of 30% could have a cost similar to the current system. If presented clearly, a 30% rate could give a larger incentive to basic rate taxpayers to save, while still leaving pension saving at least tax neutral for higher rate taxpayers.”

“But implementation of a single rate of tax relief would be far from straightforward, with significant changes in the administration of pension contributions required. The resulting tax charges could be very difficult to understand and lead to changes in behaviour by employees and employers.” (Source: Pensions Policy Institute)

Conservative MP’s call for changes

In a separate development a group of 40 Tory MP’s have called for even more radical changes to a pension system described as “rotten”.

A report from the Forty Group recommends the abolition of higher rate tax-relief and tax-free lump sums, saving £10 billion per year according to the MPs.

The wide-ranging report also looked at how Annuities are purchased and recommended changes to the current system, which would compel would-be retirees to get a minimum of three Annuity quotes and more standardisation from product providers to allow for an easier like for like comparison.

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