Tax-free lump sum sting in ‘back-to-work Budget’

Pension changes leave sour taste for some recent retirees, says interactive investor’s Head of Pensions and Savings Alice Guy.

1) Tax-free lump sum capped at £268,275

2) Lifetime allowance abolished

3) Good news for doctors and other wealthy pension savers

4) Annual pension allowance raised to £60,000

5) Money purchase allowance raised to £10,000

interactive investor welcomes the Budget changes which will make it easier for pension savers to save enough for a comfortable retirement. 

But news that the tax-free lump sum will be capped is a sting in the tail for an otherwise positive budget for pension savers. 

The lifetime allowance abolition will also be a kick in the teeth for those who already retired under the old rules.

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1) Tax-free lump sum capped at £268,275

Hidden in the Budget report is a sneaky cut to the pension tax-free lump sum. The tax-free lump sum will now be limited to £268,275, 25% of the previous lifetime allowance limit of £1,073,100. This is a change to previous rules which allowed pension savers to withdraw 25% of their total pension pot tax free up to the lifetime allowance. The tax free lump sum cap will now be separate, with the potential it could be reduced in the future.

The tax-free lump sum will be frozen in the future at £268,275, so with inflation that value will become worth less and less over time. This change may turn out to be a huge disincentive to some pension savers and it may erode one of the simplest and best-loved pension rules.

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Meanwhile, the other pension changes are a breath of fresh air for pension savers and will make it easier to save for a comfortable retirement. With life expectancies rising, more of us will need to finance a long retirement and higher pension allowance and money purchase allowances will give pension savers the ability to save more.

Lifetime allowance changes could help persuade senior doctors and others with a large pension pot to stay in work for longer, scrapping the cap on what they can pay into their pension.

However, the changes will leave a sour taste in the mouth for those who’ve retired recently under the old rules and paid a tax charge.

2) Lifetime allowance

The sigh of relief is almost audible as pension savers celebrate the scrapping of the hugely unpopular lifetime allowance. This change is well overdue as interactive investors figures show the lifetime allowance would now be worth £2.3 million if it had risen with inflation since its introduction in 2006.  (See note 1 for data)

The simplifying of the pension lifetime allowance rules will help, not only more wealthy investors, but those with modest pension savings who won’t have to worry any more about their pension being hit with high tax charges if their investments perform well. Under previous rules, even if someone’s pension pot was worth well under the lifetime allowance, they could end up breaching it later on as their investment grew. This was putting people off saving into their pension even if they were far below the LTA limit.

It was surprisingly easy to breach the old LTA limit, especially after a long working life with regular pension investing. Someone starting work at 20 and saving £500 per month until they reach retirement age at 68 could see their pension pot reach an amazing £1.2 million as even modest pension savings add up over time. (See note 2 for data)” 

The new lifetime allowance rules mean that doctors and senior public sector workers won’t have to worry about breaching the lifetime allowance if they carry on working, or they’ve stopped work and their pension investments perform well.

Previous rules meant that doctors were previously limited to a pension income of £53,655 or £40,241 if they took a 25% tax-free lump sum. Meanwhile, pension savers with a defined contribution pension were limited to a pension pot of £1,073,100, which was worth an annual pension income of £48,225, or £36,169 if they took a tax-free lump sum.

Assumptions: buying an annuity at 65-years-old which escalates 3% per year with a 50% joint life element (annuity figures from sharing pensions).

3) Good news for doctors and other wealthy pension savers

The lifetime allowance has more than halved in real terms since its introduction in 2006 and means that a 55% tax penalty, originally intended for the super-rich, caught out hard-working doctors, senior teachers and civil servants, encouraging them to leave the workplace. 

Today’s changes mean that senior consultants and other public sectors workers don’t have to worry about triggering a 55% tax charge and can carry on working and paying into their pension for longer.

But doctors nearing the lifetime allowance will be hugely disappointed that they will have their tax-free lump sum capped, rather than being able to withdraw 25% from their pension tax-free.

4) Annual allowance

It’s great news that the pension annual allowance is rising to £60,000 from its previous level of £40,000.

Many people now have squiggly career journeys and the days of a job for life are long in the past. This means they may be left making up for lost time and need to boost an ailing pension pot once they reach their 40s, 50s and early 60s.

The changes will also make it easier for self-employed workers who have the fuzzy end of the lollipop when it comes to pensions. They often have unreliable income and can earn well one year and then be struggling to pay their bills the next. Having greater pension flexibility will help them boost their pension pot in years of plenty.

5) Money purchase annual allowance

The Spring Budget is focused on the drive to get the over 50s back into work. Interactive investor comments.

The aching skills shortage and tight labour market has been one of the key themes of at least the past year, and it is inextricably linked to the cost-of-living crisis and inflation.

Today’s Spring Budget is clearly a back to work budget, as the raising of the money purchase annual allowance illustrates. It is particularly helpful for those who need to return to work for financial reasons.

Money purchase annual allowance

Many workers enter their 50s with a small pension pot and it’s a race against time to save enough for retirement. 

Raising the money purchase annual allowance from £4,000 to £10,000 is a boost for older workers who want to return to the workplace and top up their pension income. 

We are delighted that the chancellor has listened to industry calls from interactive investor and others, in an open letter led by The Lang Cat. Someone who drew taxable income from their pension at 55-years-old will potentially have another 11 years until they reach state pension age and could boost their retirement income by an extra £85,759 by paying an extra £6,000 per year into their pension for 11 years, assuming 5% investment growth.

What do changes mean for recent retirees?

For recent retirees, the rising money purchase annual allowance is great news and means older workers can return to the workplace and continue saving into their pension without having to worry about extra pension tax charges.

Someone who’s 55 and recently retired and dipped into their taxable pension can now return to the workplace and pay as much as £833 per month into their pension pot (including tax relief and employer's contributions) under the new higher MPAA cap, keeping their pension contributions under £10,000 per year. This means they can fully take advantage of employers’ pension contributions and pension tax relief, just like younger workers.

But although the rising LTA is great news for most pension savers, the changes will be a kick in the teeth for some recent retirees who have already triggered a charge. Someone who retired this year with a pension pot worth, £1.8 million would potentially have triggered an extra £181,725 tax charge. It’s also a kick in the teeth for people who have felt pressured into retiring before they were completely ready.

Notes

Lifetime allowance

Note 1.

Note 2.