Tax Free Cash - Will he or Won’t he?

by on 15·03·2016

There have been rumours about the removal of this since the run up to A-Day when the term Pension Commencement Lump Sum suspiciously had no mention of "tax-free" in the title.  Even prior to this, in his 1985 Budget, Nigel Lawson described the tax-free lump sum as "anomalous but much loved".  He subsequently decided to steer well clear of the politically suicidal move of taking this away from the British public.

Yes, the tax-free lump sum is "much loved".  People love to get something with the word free in it and it is unusual for a Budget to take something away retrospectively.  I remember in the run up to A-Day being puzzled at the apparent complexity of 'Pensions Simplification' and especially the rules surrounding PCLS protection.  There was an opportunity at that time to restrict tax-free cash to just 25% for everyone, but it was sadly not taken.

The bulk of people saving into pensions are basic rate taxpayers and the ability to take 25% of the fund tax free is the only thing that makes a pension slightly more tax advantageous than an ISA.  When you take into account the higher charges often associated with pensions then this advantage is far less apparent.  And yet a pension still seems like it should be a better savings vehicle.  The recently introduced freedom to pass a pension fund on through the generations has perhaps been the saving grace for basic rate taxpayers.

In my view the biggest danger to tax-free cash comes from the benefits enjoyed by higher-rate taxpayers.  Although I have benefited from higher rate tax relief on pensions it has always made me feel slightly uncomfortable.  The idea of getting higher rate tax relief going in and only paying basic rate tax coming out (this is certainly true for most higher-rate taxpayers) means that pension saving distinctly favours these bigger earners, and in turn this appears to be politically unacceptable these days.

As a result of innumerable tweaks to income tax bands and allowances there are more higher-rate taxpayers than ever benefitting from pensions tax relief, so it is clearly time to do something about it!

However, I have long been puzzled by how it would be possible to restrict higher rate tax relief on pensions when it is possible to sacrifice salary in exchange for a pension contribution.  The solution simply needed a bit of thinking outside the box (I didn't think of this) and to introduce a savings vehicle that has no tax relief on the way in, but is tax free on the way out.  Enter the 'Pension ISA'…

I really cannot see that any Chancellor would blatantly remove the tax-free cash benefit from pensions, but with a Pension ISA they would not need to because all the proceeds would be tax free at retirement.

Why then bother with pensions at all?  The majority of the population do not save the full £15,240 into an ISA each year anyway.  To replace two savings products with just one would certainly fit with the FAMR objective of affordable and accessible financial advice and guidance for everyone, at all stages of their lives.