Why Hunt’s reforms could shrink your 25 percent pensions tax-free cash to just 10 percent in 10 years

3 minute read Last reviewed: June 2024

Clients with larger pension funds risk losing thousands of pounds that can be taken tax-free from their pension if they fail to take action.

In the March budget, the Chancellor announced he would abolish the pensions lifetime allowance, which had capped the total amount savers can hold in their pension pots without incurring a tax charge at £1,073,100. While previously, people could take the lower of 25 per cent of their pension fund or 25 percent of the lifetime allowance as a tax-free lump sum, the Chancellor’s reforms set a new maximum limit of £268,275, which currently has no provision for future increases.

This has major knock-on consequences for pension planning. Those who have reached or are set to reach the previous lifetime allowance will see the amount of tax-free cash available to them shrink in percentage terms and in purchasing power as their pension grows.

Over five years years they could lose nearly £37,000 of available tax-free cash at retirement in real terms, with 81% of their pension becoming subject to tax on withdrawal. Over ten years, the real value of tax-free cash could shrink by almost £70,000, with 86% of the pension subject to tax.

The effect of fiscal drag on pensions tax-free cash

Timing	Fund value	Max tax-free cash	Tax-free cash percentage	Max tax-free cash after inflation*	Tax free cash percentage after inflation*
Today	£1,073,100	£268,275	25%	£268,275	25%
5 years’ time	£1,436,050	£268,275	19%	£231,416	16%
10 years’ times	£1,921,759	£268,275	14%	£199,622	10%

*Assumes 6% annual investment growth rate and 3% inflation.

‘Crystallisation conundrum’

Those with large pension funds are facing a crystallisation conundrum. A pension becomes 'crystallised' as soon as you withdraw retirement benefits like tax-free cash from your pension fund. Savers are having to decide whether to crystalise earlier than planned and invest their tax-free cash in other products like ISAs and insurance bonds to both protect and make their tax-free cash rights work harder. This decision is made more complex due to the advantageous inheritance tax status of pensions on death.

Roddy Munro, head of tax and pensions specialists at Quilter says:

“With savers already impacted by fiscal drag as well as the reduction in the capital gains annual exempt amount and the dividend allowance, now those with large pension funds will soon feel the full effect of the freezing of the amount they can take tax-free from their pensions.

“The impact of the Chancellor’s recent visits to the dispatch box will have major consequences for those who, through careful financial planning, have accrued significant pension wealth. The practice of fiscal drag, where tax thresholds and allowances do not keep track with increasing inflation or wage growth is not widely appreciated. The government is banking on general ignorance of the impact of such fiscal drag to increase the tax take by stealth, but people can act as there are a number of ways to avoid these Machiavellian reforms.

“While everyone’s individual situation will differ, some people with larger pensions are deciding to take their tax-free cash earlier and utilise other products. Where this is the case, it is important that people consider the likes of ISAs and insurance bonds to shield their long-term savings from the tax man should their pension be above the traditional lifetime allowance. Insurance bonds in particular are back in vogue following these reforms as they can help to control the tax payable, simplify tax reporting and sit within a trust for inheritance tax planning purposes.

“Around 1.6 million people were set to breach the previous lifetime allowance by 2026 with many more set to breach it in years to come. Now, some of these will include defined benefit pension holders where they have a different set of rules to contend with, but those in more common defined contribution pension schemes will now have to consider more complex planning to protect their tax-free cash amount. This is against the backdrop of an election year in 2024, which could see Hunt’s pension reforms reversed if Labour come to power. The best outcome for consumers will very much be driven by their own and their family’s circumstances, so taking professional advice will be critical.”

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