How to protect your tax-free pension lump sum from a Labour Budget raid

Rumours are swirling that one of the greatest perks of saving for retirement could be under threat in the Chancellor’s Budget at the end of the month.

The ability to take 25 per cent of your pension savings tax free has for decades been a much-loved feature of pension saving – and is a key feature of the retirement plans of millions of savers.

Savers use the tax-free cash to help fulfil their retirement dreams: to top up their income if they semi-retire, to take a well-earned holiday, pay off a mortgage or help loved ones to boost their savings or buy a home. It can be taken from the age of 55, or 57 from 2028.

But as the Chancellor Rachel Reeves looks for taxes that she can raise and perks that she can slash to boost the Treasury’s coffers, fears are mounting that the beloved tax-free lump sum could be in her sights.

The Chancellor was labelled ‘Robber Reeves’ by protesters against the Winter Fuel Allowance cuts who gathered outside Parliament earlier this week.

Wealth managers, financial advisers and pension providers tell Money Mail their call centres are heaving and experts in heavy demand from worried savers with two questions on their lips: is the tax-free lump sum under threat and should I take mine now while I still can?

Experts are urging the Government to provide urgent clarity to worried savers. Helen Morrissey, head of retirement analysis at wealth platform Hargreaves Lansdown says: ‘The Government has left people to make impossible decisions about their investments and pensions. 

‘The sooner changes, such as raiding tax-free cash, can be ruled out, the more people can focus on the long term again.’

Wealth managers say they are urging clients not to make rash decisions they may later regret – especially if the tax-free lump sum remains unchanged. 

They say savers need to think very carefully before taking tax-free cash as there can be implications for inheritance tax, capital gains tax and how much they have to retire on.

But there are some tricks that savvy savers can use to make the most out of the situation.

Only take what is shielded from tax

While money is in your pension it grows free of tax. But as soon as you take it out, it is exposed again. 

There may not be income tax to pay when you withdraw your 25 per cent tax free lump sum, but it could attract tax later on, for example if you put the money into a savings account where it earns more than £1,000 in interest every year (or £500 if you’re a higher-rate taxpayer). 

The protection of a pension is rarely worth forfeiting unless you have specific plans for how you will use the cash.

But one trick that allows you to bank some tax-free cash is only to take as much as you can fit into an Isa.

Like pensions, Isas also shield your wealth from tax and allow your money to grow without paying a penny on dividends, capital gains or interest earned.

So you could take tax-free cash from your pension, put it into your Isa without paying tax – and once it’s there your wealth can continue to grow tax free.

Everyone has an Isa allowance of £20,000 each tax year. So you could take £20,000 if you still have your full allowance available. Children also have a Junior Isa allowance of up to £9,000. 

If you wanted to help children out, you could in theory use your allowance, your spouse or civil partner could do the same, and chip into the Junior Isas as well. 

For a family of four that would add up to a total of £58,000 completely shielded from tax – and any changes made by the Chancellor.

You don’t have to take your full tax-free lump sum – there’s nothing to stop you taking only what you need or can shield from tax. 

If you keep the remainder of your allowance in your pension for longer, it gives it even more time to grow, which could grant you an even greater tax-free lump sum in the long term.

Apply for special protection

Should the Chancellor make changes to the tax-free lump sum, she is very unlikely to get rid of it altogether.

It is far more likely that she will reduce the amount that you can take tax free from the current upper limit of £268,275.

But were she to reduce the cap, there is a good chance that she would put something in place for savers who would already fall foul of the new rules. 

Clare Moffat, from pensions firm Royal London, says chancellors have always offered this kind of lifeline in the past.

‘If the Chancellor does reduce the cap, I would expect her to put rules in place to protect those people who have enough saved that they would breach the new cap,’ she says. ‘Otherwise the new legislation would be retrospective, which does not seem fair.’

If you do fall foul of any new rules introduced, be ready to apply for permission to maintain your benefits under the old ones.

Don’t worry unless you have a large pot

Influential think-tanks the Institute for Fiscal Studies and the Fabian Society are recommending that the Chancellor slashes the limit from £268,275 to £100,000. 

Were this to happen, savers would not be affected unless they had more than £400,000 saved in pension wealth. Few retirees have pots of this size.

Of course, she could slash it further – or restrict the lump sum in another way, such as reducing the percentage that can be taken or having stingier rules for higher and additional rate taxpayers. 

But it is probable that any changes are unlikely to target those with the smallest pots. 

And as Jessica Beard explains overleaf, Rachel Reeves may not change the tax-free lump sum rules at all – there are plenty of other allowances that she could go after instead.

Act now if you have plans

What you don’t want is to take a load of tax-free cash just for the sake of it and to leave it sitting in a low-paying savings account when it could have been growing nicely in your pension. 

As Steven Cameron, pensions director at provider Aegon says: ‘It’s generally not a good idea to take money out of your pension unless you know how you’ll spend it.’

But, if you plan to take a tax-free lump sum soon and have a specific purpose for it, you could consider banking it now to be on the safe side. The key is to think through the decision carefully and work out all the implications.

Dan Boardman-Weston, chief executive of advisers BRI Wealth Management, says: ‘As a general rule of thumb, it’s usually not sensible to pre-empt potential tax changes and we’d advise clients not to be making knee-jerk decisions on speculation.

‘However, if you are already planning to take some or all of your tax-free cash in the near future then it may make sense to accelerate the timing of that.’

Remember there is no need to take all of your tax-free cash at once; you can take it in lump sums as you need it. 

A good financial adviser can help you plan the most tax efficient ways to take tax-free and taxable cash from your pension.

However tempting it may be to change tack and take out more than you planned in case the rules change in the Budget, you may find that the benefits are far outweighed by the harm it would cause to your retirement plans. Speaking to an adviser first is key.

Beware of the unintended tax traps

Taking money from your pension may seem straightforward, but there are all sorts of implications. 

For example, pension pots can be passed on free of inheritance tax (although loved ones will pay income tax if you die after the age of 75). 

But, if you take a tax-free lump sum, that money may not be afforded the same protection, should your estate exceed your inheritance tax allowances.

Once you take money from a pension, you are restricted as to how much you can subsequently pay into them. 

So, for example, if you take your tax-free lump sum and continue to work, you will find that you can only pay £10,000 a year into your pension instead of £60,000. 

That could be devastating to your retirement planning if you had hoped to boost your pension pot in your final years of work. Some people, for example, will pay in larger sums after selling a business or downsizing. 

If you work in the public sector, you may even have to stop working if you take a lump sum.

All of these factors will need to be considered, which is why it can be worth getting financial advice. Ask friends and families for personal recommendations, or use a directory such as unbiased.co.uk to find a regulated adviser near you.

The Government also offers free guidance through its Pension Wise service. Go to: moneyhelper.org.uk.

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