Prepare for pension changes in the Budget

Chancellor Rachel Reeves has ruled out cutting pension tax relief for higher-rate taxpayers, according to The Times. This would have made pension contributions less attractive for anybody earning more than £50,270 – higher and additional-rate taxpayers currently receive full income tax relief on pension contributions, at rates of 40 per cent and 45 per cent, respectively.

Reducing this tax break, perhaps even replacing it with a flat 20 per cent rate of relief for everyone in line with the basic rate of income tax, would have raised much-needed funds for the Treasury. Reeves is certainly not the first chancellor to have been tempted over the years.

But it would also have been very inconvenient, politically: for one thing, the move would have impacted a lot of public sector workers whose salaries are not especially high. Because income tax brackets have been frozen since 2021-22, the £50,270 threshold has lost a lot of its real value. This, incidentally, is another reason why freezing income tax thresholds was a bad idea in the first place – it distorts the system and is a short-termist approach.

But despite the good news on tax relief, other changes to pension taxation remain on the cards. Labour originally planned to reinstate the lifetime allowance, and while it has long since reversed course on this front, the government could be looking for less complex ways of reducing the tax advantages enjoyed by high-value pensions.  

Last month, the Institute for Fiscal Studies, the influential think tank, looked at possible options. It argued against reducing income tax relief, suggesting three possible alternatives. 

The chancellor could cut the 25 per cent pension tax-free lump sum. The lump sum allowance currently caps the maximum amount you can take in tax-free cash from your pensions at £268,275, but this could be reduced, for example to £100,000. Jason Hollands, managing director at Evelyn Partners, says that if done without transitional arrangements, this would be an “incendiary move”. Many pension savers “have had long-term plans in place for their tax-free cash, like using it to help pay off a mortgage or clear other debts ahead of retirement”, he points out.

Subjecting pensions to inheritance tax (IHT), from which they are currently exempt, would be less controversial. The government does appear keen on reducing IHT relief options, and this move would also have a less immediate impact on doctors and public sector workers. But it would still drag a lot more estates above the £325,000 IHT tax-free threshold, which has also been frozen for a long time, and potentially expose at least some pensions to the 40 per cent IHT rate when passed on to beneficiaries.

Finally, the government could start levying national insurance on employer pension contributions. This option would have the benefit of raising significant cash with no instant consequences for the vast majority of pension savers; but it would prove very costly for businesses – who may in turn decide to reduce their contributions. 

As always, the main issue is that, by definition, pensions require long-term planning, which means tweaking the rules every couple of years is generally unhelpful and can push people into impulsive decisions. Advisers are reporting an increase in people wanting to take out their tax-free cash ahead of potential changes in the Budget. If that’s you, remember not to do anything rash – if you don’t have a plan for your tax-free cash and you take it out, it will just sit in a savings account or a general investment account, potentially accruing income tax, CGT and even IHT.