Each year, speculation ahead of the Budget sparks nervousness among pension savers.
Last year, many expected the Government to restrict the 25 per cent tax-free lump sum available from pensions or reduce higher rate tax relief on contributions.
Neither change materialised, but pension providers reported a spike in withdrawals before the announcement, with some savers potentially harming their long-term planning by rushing to act on rumours.
At present, individuals can usually take up to 25 per cent of their pension pot tax-free, subject to the Lump Sum Allowance (LSA) of £268,275. The rest is subject to Income Tax when withdrawn.
But what if the Chancellor decided to scale back this long-standing perk?
Possible reforms
There are a few ways the Treasury could restrict this relief:
- Reducing the overall cap – Cutting the current £268,275 limit would mean fewer savers could maximise their 25 per cent tax-free entitlement.
- Lowering the percentage – Reducing the 25 per cent figure to, say, 20 per cent would directly increase the tax impact of withdrawals for everyone.
- Abolishing the relief altogether – The most drastic option, treating all pension withdrawals as taxable income.
Tax impact
Such changes would have immediate and far-reaching tax consequences:
- Higher Income Tax bills – More of each pension withdrawal would fall into the Income Tax net, particularly pushing larger withdrawals into higher-rate bands, directly increasing the tax payable.
- Less flexibility for retirement planning – Many people use the tax-free lump sum to clear mortgages, pay off debts or fund major purchases. If reduced, they may have to withdraw more from their pension fund (and pay more tax) to achieve the same outcome, leaving less available in retirement.
Behavioural impact
If a change were announced, savers might again rush to access their pension pots before new rules take effect.
While understandable, acting on speculation can create long-term issues, withdrawing too early may mean losing investment growth or facing unintended tax bills down the line.
A return to tax relief reform?
While the most recent rumours focus on tax-free cash, higher-rate tax relief on pension contributions remains another potential lever for the Treasury. Removing or capping relief for 40 per cent and 45 per cent taxpayers could raise substantial sums — but would be politically contentious.
The 25 per cent tax-free pension lump sum is one of the most popular and valuable reliefs available to savers.
If cut, it would mean higher Income Tax bills in retirement and less financial flexibility for individuals.
Our team will be summarising the key elements of the budget on the day, so look out for our commentary with key insights and updates.