If you’ve been keeping up with financial policy news over the last 12 months, you’ll have seen an enormous range of changes.
In September 2022, we saw Kwasi Kwarteng’s disastrous mini-Budget, in which the then-chancellor announced the scrapping of the additional-rate tax band and other changes that were subsequently repealed.
Then, in the 2023 spring Budget, current chancellor Jeremy Hunt unexpectedly removed the pension Lifetime Allowance (LTA) charge, with plans to entirely scrap the limit in future.
Changes like these can make planning for your future feel far more difficult and uncertain.
One such change you may have seen in the news that could affect you was the proposal in February by the Institute for Fiscal Studies (IFS) – a London-based economic research institute – which recommended removing and reforming the 25% pension tax-free lump sum.
Many pre-retirees carefully consider how they’re going to make use of this tax break, meaning it could cause havoc to individuals’ plans if it were to be removed.
So, find out how the 25% tax-free lump sum works, why the IFS has proposed scrapping it, and how financial planning can help you to overcome changes like this.
Taking 25% of your pension without facing a tax bill
In 2015, the government introduced the new Pension Freedoms legislation to give individuals greater control over their retirement funds. Part of this included the introduction of the 25% pension tax-free lump sum, which has become one of the most useful tools in the retirement planning toolbox.
Using it, you can take a 25% tax-free lump sum from your pension when you reach the normal minimum pension age. In 2023/24, this is 55, although it is set to rise to 57 in 2028. You can then draw the rest of your fund as and when you choose, with it being taxed as income.
Alternatively, you can choose to take your pension as multiple, smaller lump sums, of which 25% is tax-free and the rest is taxed as income.
This can allow you to take your tax-free lump sum while leaving the remainder of your pot invested to potentially continue generating returns.
Although the pension LTA charge has been removed – and the entire threshold is to be abolished in a future Finance Bill – the maximum amount you can take as a tax-free lump sum is still restricted to 25% of the previous LTA.
As the LTA is currently £1,073,100 in 2023/24, the maximum you can take tax-free is £268,275.
You’re then free to use your lump sum in any way you see fit. Common goals include using it to pay off a mortgage, buy an annuity, fund home renovations, go on a dream holiday, or explore flexi-retirement options such as going part-time at work.
The IFS has suggested removing the lump sum and reforming it
As reported in FTAdviser, the reason the 25% tax-free lump sum is under scrutiny is because the IFS has proposed reforming it entirely.
The IFS believes that this would go some way in solving inequality in retirement income. It argues that the current system only benefits those with high incomes, while non-taxpayers receive no benefit whatsoever.
Its suggestion is to instead cap the tax-free component, limiting it to 25% of the first £400,000 of your pension wealth – meaning you would only be able to take a maximum of £100,000 as a tax-free lump sum.
You can see how this could affect your retirement income, reducing the amount you could potentially take from your pension tax-free by more than £150,000.
The everchanging landscape shows the importance of robust planning
Currently, the IFS’s proposals are nothing more than a suggestion. If you’re planning for your dream retirement, you may well want to factor your 25% tax-free lump sum at the current limit into your calculations, because it remains a powerful tool for reaching your later-life goals.
That said, while this change may be theoretical now, there’s nothing to say that rules may not change in the future.
The government may heed the IFS’s suggestion or not. But either way, the overwhelming likelihood is that policy changes will come into place that do affect you, whether that’s before or after you retire.
The key here is to plan for the future so that you can live the type of lifestyle you want in retirement, regardless of these changes. This is where financial planning can add real value.
By working with an expert adviser, you can work out what you need and how to use your wealth based around your specific goals for the future.
This way, you can also build contingencies into your plan that prepare you for such changes and ensure that you remain on track to meet your targets, no matter what happens at policy level.
Speak to us
If you would like to find out how you can achieve the retirement you want, we can help at Cordiner Wealth.
Please email firstname.lastname@example.org or call 0113 262 1242 to speak to an experienced adviser today.
A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits.
This blog is for general information only and does not constitute advice. The information is aimed at retail clients only. All contents are based on our understanding of HMRC legislation, which is subject to change.