Reducing pension tax-free lump sum to £100k a ‘high risk’, Reeves warned

Pensions minister Torsten Bell has previously called for the tax-free cash amount to be capped

Rachel Reeves has been warned that making changes in the Budget to the amount of cash people can withdraw tax-free from their pensions is a “high-risk strategy” which would create a “political storm”.

The Chancellor is looking at a range of tax rises to try to fill and £20bn-£40bn hole in her budget without breaking her manifesto pledge not to raise income tax, VAT or employee national insurance contributions.

A significant source of funding would be to reduce the amount pension savers can take from their pot tax-free each year.

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A new report from the Institute for Fiscal Studies has recommended that the Chancellor should look at reforming this tax-free element which retirees can take from their pension income.

In its report, the IFS said that the tax-free 25 per cent offered on all pension withdrawals up to a cap of £268,275 was “ripe for reform”.

It added that the current system provided the largest benefit to those with the highest retirement incomes, and “subsidises saving for those who have already accumulated big pension pots and are at no risk of under-saving”.

It has previously recommended cutting the 25 per cent tax-free cap to £100,000, estimating this would affect one in five pensions and raise around £2bn a year.

With Reeves expected to have to raise tens of billions in her Budget to fill a gap in the public finances, some experts think a change to the way pensions are taxed could be on the way.

Rob Wood, chief UK economist of Pantheon Macroeconomics, told The i Paper: “We expect the Chancellor to lower the maximum tax-free lump sum to £100,000.”

He added: “Taxes always create distortions so the Chancellor should be mindful of the impact on the incentives to save,” but “equally, allowing a large sum to be withdrawn from a pension free of further tax is worthy of reform.”

Pensions minister Torsten Bell – who has been given an elevated role in helping to shape the Budget – previously called for tax-free cash to be capped at £40,000 when he was running the Resolution Foundation think tank.

When asked, the Treasury did not dampen speculation. In a statement it said: “We do not comment on speculation around tax changes but remain committed to encouraging pension saving.

“Pension-savers already benefit from around £78 billion a year in tax reliefs as the majority pay no tax on their contributions.”

However, Steve Webb, a partner at pensions consultants LCP and a former pensions minister, warned that such a move would backfire on Reeves.

“Touching tax-free cash would be a high risk strategy for the Chancellor,” he said.

“A particular challenge is that those close to pension age would need to be protected from a last-minute change to the tax rules. But as soon as you create complex protections, you end up raising little money from the policy for years to come.

“Creating a political storm by attacking the ‘sacred cow’ of tax-free cash whilst generating very little revenue before the election feels like a lose-lose for the Chancellor.”