Just how sacred is tax-free cash?

We have recently had a flurry of proposals for changes to pensions taxation rules. Two of these – from the Resolution Foundation and the Institute of Fiscal Studies (IFS) – are calling for a cap to the amount of tax-free cash. Although they ended up with (virtually) the same proposal, the two thinktanks arrived there by taking different routes.

The Resolution Foundation is concerned about the concentrated level of economic inactivity amongst older people following the pandemic. In its report ‘Post-Pandemic Participation’ it noted that unemployed older people from low-income households tended to be sick, and those from higher-income households were relying on private pension income. Therefore, it reasons, cut the level of private pensions someone can take before state pension age. In particular it believes the tax-free cash – usually 25% of pensions benefits crystallised – is generous, allowing many people to initially rely on that alone. However, it stopped short at naming a capped figure.

The IFS came at their proposal in a different way. It wants a wholesale review of pensions taxation to create a fairer distribution of the tax incentives. As well as other wide-ranging changes, it suggested capping tax-free cash at £100,000.

Its argument was that as well as being overly generous, tax-free cash was considerably more valuable to those who are higher-rate (or additional-rate) taxpayers in retirement, compared to those who may not even have taxable earnings. Once again, pension tax incentives were favouring the wealthier. The IFS also argued the tax rules encouraged people to take the tax-free cash instead of using the money to provide an income.

The IFS flirted briefly with the idea of abolishing tax-free cash altogether, before deciding a more realistic option would be to cap it. Either by reducing the percentage – say down to 20% – or by capping the amount. It landed on a suggested £100,000 maximum, although it isn’t wedded to this figure.

It’s understandable why capping the tax-free cash got such a starring role in these proposals. After all it’s an easy lever to pull. But in practice, there are two main pushbacks.

First, do you introduce it at midnight on 16 March, affecting anyone who takes benefits from this date? Or if not, then how do you do it?

The IFS, to their credit, explored this. As well as the ‘big bang’ option, it argued transitional arrangements could introduce it gradually, maybe in line with age. So those within easy reach of state pension age get to keep their entitlement, and those further out would gradually be restricted to only £100,000.

The obvious problem is millions of pension savers have agreed to lock their money in pensions for decades in part because they were told they could get a quarter of their pot tax-free when they reached the minimum access age.

Even with the IFS’s gradual transition, some would feel they are losing out on that promise on the amount they have already saved, and instead would want total protection. If they didn’t get this, it would be a body blow to their trust in retirement saving.

And that brings me neatly to the second big pushback. Tax-free cash is understandably a popular part of pension saving. Most pension savers would be at a loss to explain qualifying earnings, annual allowances, and the lifetime allowance. But they could tell you they get a quarter of their pot as cash when they retire.

Tinkering or even removing this recognised and valued feature could undermine pension savings incentives, so doing a lot of damage to pension saving in the UK.

So, how likely is it these tax-free cash proposals will make it to law? They are being made in the run up to the Spring Budget on 15 March. Timing is, however, everything. This government only has another 20 months (at most) to run, and it’s probably unlikely it’s going to introduce such a big change to pension tax rules at such a late stage. Especially such an unpopular one – a cap of £100,000 would affect one in five retirees, but importantly almost half of public sector employees, promising more public sector unrest.

We don’t know the colour of the new government, nor by how much they will be prepared to put forward bold ideas for pensions taxation at the start of a new term. The opposition benches, current backbenchers, or public servants may be listening to these ideas with interest.

Tax-free cash is an important, highly recognisable part of our pension tax rules. To cap it would be a daring, audacious move. But with automatic enrolment opt out rates standing at around 10%, despite a pandemic – showing many workers are too apathetic to opt out – some may argue it could be attempted, especially as part of wider wholesale changes.

Maybe tax-free cash isn’t that sacred after all.