UK Pensions: The IFS’s reform commendations explained
The Institute for Fiscal Studies has proposed capping the tax-free lump sum for pensions in the UK at £100,000.
The current system allows people to access a 25% tax-free lump sum from their pension pot, often used for big purchases like paying off a mortgage, home improvement, or funding a dream holiday. The IFS argues that the current system provides a large tax subsidy to those with high pensions and incomes and does little to support low-income retirees.
The proposed cap – if adopted – would only affect 20% of retirees (those with pension pots greater than £400,000) and could be accompanied by subsidies for basic-rate taxpayers and non-taxpayers.
The reaction from industry experts has been one of resistance – most believe it would harm pension savings. The IFS claims that their proposal would boost the retirement incomes of 80% of low-income earners and encourage more pension savings while removing excessive subsidies for high-income earners.
The IFS has also proposed the following reforms in addition to changing the 25% tax-free lump sum rule:
Reform the lifetime allowance and eliminate the tapering of the annual allowance
The IFS believes that the cuts to the lifetime and annual limits on the amount that can be saved tax-free in a pension have become too complex and discourage higher earners from saving. The proposed reforms would remove excessive generosity in the current system and make it easier for policymakers to be more relaxed about these limits.
Provide upfront employee National Insurance (NIC) relief on all pension contributions and tax pension income instead
There is no upfront NIC relief on employee contributions, only on income tax. The IFS suggests gradually moving to a system where all private pension income is subject to employee NICs. This would align the income tax and employee NIC systems and benefit low and middle-income earners who make individual contributions at the expense of higher earners with big employer pension contributions.
Apply employer NICs to employer pension contributions
The IFS believes that employer pension contributions should not be exempt from employer NICs, especially since this tax break has no value when employers are not liable for employer NICs, such as small employers.
Financial Adviser, Jonathan Brookes, had this to say:
“If adopted as policy, the proposals will likely drastically impact the retirement planning process. Particularly for higher earners or those with final salary / defined benefit pensions where the lump sum is pre-determined.
Whilst in principle, a potential rise in the amount allowed to be taken tax-free from a pension for individuals with pots smaller than £400,000 is welcome, this will only increase their income once. However, this is likely to have a detrimental effect on the amount left available to fund the remainder of their retirement. In other words, this could have the opposite effect intended by encouraging more people to empty their pensions earlier.
It would be very unfair if these rules were applied retrospectively to those who have not yet retired but made plans based on the current rules.
Charging NICs on employer contributions is counterintuitive, and the current reliefs are in place to encourage saving into pensions. Likewise, charging NIC on pension income feels like tinkering around the edges. If there is genuine concern about disparity in NICs between higher and lower earners, then there should be an overhaul of the whole system, not a piecemeal approach.”
Lifetime Allowance and Annual Allowance
The lifetime allowance and annual allowance are two rules that limit the amount of money you can save tax-free in a pension plan in the UK. The lifetime allowance sets a cap on the total amount you can accumulate in your pension, and the annual allowance limits the amount you can contribute to your pension in a single year.
If you exceed these limits, you may have to pay a tax charge on the excess amount. Currently, the lifetime allowance is £1,073,100, and the annual allowance Is £40,000.
Accessing your 25% tax-free lump sum
The best way to access your 25% tax-free lump sum depends on your financial situation and goals. Here are some steps you can follow:
Decide when to take your lump sum
Depending on your pension scheme, you can typically take your lump sum at the age of 55 or later. Consider your health, future expenses, and expected retirement age.
Review your pension options
Some pension schemes offer flexible access options, while others may require you to take your lump sum all at once. Review your options and choose the one that best suits your needs.
Consider the tax implications
Your lump sum may be taxed if you take more than the 25% tax-free amount, so it’s essential to be aware of the tax implications of your decision.
If you have any doubts or concerns, it may be a good idea to seek professional financial advice to help you make an informed decision.
It’s important to note that accessing your lump sum may impact your long-term retirement income, so it’s crucial to consider your options carefully and make a decision that aligns with your financial goals. If you’d like to speak to one of our retirement planning specialists, get in touch today via the form below, and we can arrange a free discovery consultation for you.