Abolishing the 25 per cent tax-free cash lump sum is one of the options under consideration by the Treasury as it looks to plug a £20bn tax loophole created by its flagship policy of freedom and choice in pensions.
The Treasury has been told it must remove some of the tax advantages of pensions or risk losing three-quarters of tax receipts from workers over age 55 if it presses ahead with the policy of allowing retirees to access their entire pot whenever they want.
Removing or reducing the scope of the tax-free lump sum would be an embarrassing climbdown for Chancellor George Osborne.
Osborne pledged to keep the tax-free lump sum in the Budget speech he used to unveil the biggest relaxation of pension withdrawal rules for 90 years, a policy that has until now been widely praised as a political master stroke.
The Treasury is consulting industry tax specialists on ways to stop individuals and employers exploiting its Budget proposal for an unprecedented liberalisation of the process for withdrawing pensions.
Axing the 25 per cent tax-free lump sum and levying of National Insurance contributions of 13.8 and 12 per cent respectively on employer and employee pension contributions are both at the top of the agenda.
Experts say the Government has no option but to take some steps to make pensions less attractive pre-retirement. If it does not, it will open the door to workers aged 55 and over paying 73 per cent less tax through salary sacrifice.
By opting to receive no salary at all, and instead have their entire remuneration paid directly into their pension, employees and employers will be able to make huge tax savings under the Chancellor’s plans.
Individuals can receive up to £40,000 in pension contributions in a tax year. Paid as salary, employee NI contributions of 12 per cent and employer NI contributions of 13.8 per cent are due on all earnings above £7,956.
But no NI is payable by employers or employees on contributions into a pension, and 25 per cent of the money can be taken tax-free.
Under the freedom and choice in pensions policy unveiled by the Chancellor in the Budget, someone over age 55 would be able to draw the entire amount as cash, a quarter of which is tax-free, and the remainder liable for income tax at 20 per cent.
For an individual paid £40,000 a year as salary, HM Revenue & Customs receives £14,267.35.
But if the individual paid the minimum wage for a 35-hour week, being £11,484.20, and the balance is paid into the employer’s pension, HMRC receives just £5,484.48, a cost to the public purse of £8,782.87, which is 62 per cent less.
If all employees between age 55 and 64 opted to be paid in this way, the cost to the Treasury would approach £20bn.
Abolishing tax-free cash, described by then-Chancellor Nigel Lawson in his 1985 Budget as “anomalous but much-loved”, would be politically sensitive.
The Treasury is understood to be looking to soften the blow to pensions by allowing 25 per cent of the growth in your pension fund to be taken tax free, but not allowing the relief on an individual’s original contributions. Another option is not allowing further contributions once pension benefits have been drawn.
Grant Thornton director Mike Warburton says: “There are a lot of people tied into mortgages planning to using their tax-free cash to clear them in their late 50s. This will cause them real problems.
“The word is that one week before the Budget came out, it was not looking like this at all, but at the last minute George Osborne said let’s just go for complete freedom. It may be they did not think that these complications would rise and have underestimated the fallout.”
Centre for Policy Studies research fellow Michael Johnson said: “What we are seeing is the rapid disintegration of the tax reliefs wrapped around pensions, of which tax-free cash, which costs £4bn a year, is one of the most ineffective.
“The pensions vehicle has been rattling for years and bits are now starting to fly off.”
The Treasury has denied that tax-free cash is at risk.
Nick McBreen, IFA, Worldwide Financial Planning
”Removing tax-free cash would be counter-productive. The Chancellor has just announced reforms that make pensions far more attractive but those changes would potentially unravel if one of the main incentives to save through a pension was scrapped.”