IFS calls for government to scrap 25% tax-free lump sum

In a report published on February 6, the think-tank suggested ways to even out tax support for pension saving – reducing subsidies where they are overly generous and increasing them where incentives are weaker.

The IFS said the current pension tax system does relatively little to support many of those facing low income in retirement, while arguing that reducing limits on pension saving – the route taken in recent years – is not a good solution.

As part of the reforms, it suggested removing the 25 per cent tax-free component to provide a more equal subsidy to all private pensions, benefiting those with a low retirement income. 

At present, individuals can take a quarter of their pension free of income tax. 

While popular, the IFS said this provides a large tax subsidy to those with high incomes and big pensions, but is of no value at all to those with the lowest incomes in retirement: non-taxpayers. 

At a minimum, it said the tax-free lump sum should be capped so that it only applies to 25 per cent of the first £400,000, for example, of accumulated pension wealth.

“This would still leave about four in five of those approaching retirement unaffected,” the IFS said.

“Going further, we propose providing the equivalent of a capped 25 per cent tax-free component for basic rate taxpayers, but designed in a way that increases the after-tax value of everyone’s pension (up to the cap) by the same proportion – basic rate, higher rate and non-taxpayers alike. 

“A 6.25 per cent taxable top-up on all pension withdrawals would achieve this. There would be a case for providing a bigger top-up on withdrawals made via an annuity (which provides a secure retirement income) and a smaller one for other withdrawals.”

The lifetime and annual limits on the amount that can be saved free of income tax in a pension have been cut sharply since 2011, especially for the highest earners, raising taxes by an estimated £8bn a year.

The IFS said this has created complexity and damaging disincentives for an increasing number of higher earners. 

It proposed that the government should:

• consider making the annual allowance much more generous and end the policy of tapering annual allowances for very high earners;

• reform and then consider increasing the lifetime allowance. For defined benefit arrangements, set a cap on the pension benefits; for defined contribution arrangements, replacing the current lifetime allowance with a lifetime contribution cap. 

IFS research economist and author of the report Isaac Delestre said pension saving is treated generously for high earners. 

He said: “Our proposals would boost the retirement incomes of low and middle earners and provide greater encouragement for them to save more in a pension.

“They provide a coherent vision for the taxation of pensions and don’t require the complexity — and big losses for some current basic rate taxpayers — that would result from restricting income tax relief to the basic rate, for which some have argued. 

“This evening out of tax support for pension saving would be more equitable and more economically efficient, and would allow the current set of poorly designed limits on what individuals can save in a pension to be relaxed.”

Responding to the proposals, a HM Treasury spokesperson said: “We want to encourage pension saving to help make sure that people have what they need throughout retirement. That’s why, for the majority of savers, pension contributions are tax-free.

“And our reforms in 2010 to the annual allowance and lifetime allowance, which were necessary to deliver a fair system, only affect the wealthiest pension savers.”

This article first appeared on FTAdviser.com