Each time a chancellor seeks to reduce government spending, pension schemes often come into the spotlight due to their generous tax allowances. Currently, pensions represent a significant annual expense for the treasury, amounting to approximately £48.7 billion.

Recent discussions suggest that alongside adjustments to inheritance tax and national insurance, Rachel Reeves may also consider limiting the tax-free lump sum that individuals can withdraw from their pensions.

Pension contributions benefit from income tax relief, effectively allowing savers to reclaim 20%, 40%, or even 45% of the tax they have already paid on their earnings. This means that a £1 contribution to a pension effectively costs a basic rate taxpayer only 80p, while for higher rate taxpayers, it’s just 60p.

Over time, the contributions grow without incurring taxes, and once individuals begin to withdraw funds, income tax applies. However, after reaching state pension age, they are exempt from national insurance contributions.

The government currently allows an additional 25% of pension savings to be withdrawn tax-free, a measure that significantly favors wealthier savers. Such provisions enable individuals to withdraw as much as £268,275 without any tax obligations.

There are indications that Reeves is contemplating reducing this tax-free threshold to £100,000, which could target those considered the most affluent savers. According to the Institute for Fiscal Studies, this change could impact one in five retirees.

While there has been considerable backlash regarding these proposed changes, there is a compelling argument for their implementation. The current tax-free lump sum is notably excessive and increasingly difficult to defend.

Redirecting the estimated £2 billion in potential savings from this reform could serve to enhance auto-enrollment for younger savers, assist first-time homebuyers, or reform the burdensome student loan system.

Although it is essential to reward savers, individuals have already benefited from tax relief during the contribution phase—so why maintain similar advantages during withdrawal?

A reduction to £100,000 would primarily affect those with pension pots exceeding £400,000, a demographic not in need of financial enhancement. The Office for National Statistics reports that men aged 55 to 64 typically hold an average pension wealth of £228,000, while for women it is £152,000. Moreover, one in five adults have no pension savings whatsoever.

Even committed savers may find it challenging to build a pension robust enough to feel the impact of this proposed change.

The average entry-level salary for individuals aged 18 to 21 is around £22,900. A young person earning this amount and contributing the minimum auto-enrollment rate of 8% could expect to have a pension pot nearing £400,000 by age 68, assuming a modest annual wage increase of 1% and a 5% annual investment return over 50 years.

This individual would still be eligible to withdraw £100,000 as a tax-free lump sum, even without accounting for potential interruptions in contributions due to life events like starting a family or traveling. (Public service pensions, however, operate under different regulations.)

If pensions were introduced today, even without the option for tax-free cash withdrawals, they would still appear exceedingly attractive: contributions receive tax relief, there are no taxes on investment gains, and inheritance tax is waived on leftover pension funds. Additionally, if a pension holder passes away before age 75, their beneficiaries will not incur income tax on inherited pensions.

Implementing an immediate cutoff for tax-free withdrawals would be both inequitable and ill-considered. Abrupt changes could jeopardize retirement plans, thus a gradual, phased approach would be more appropriate.

Altering pension tax regulations may pose challenges and face public dissent. Many will oppose any reduction in pension tax breaks. However, in a financial landscape where savings are increasingly crucial, perhaps Reeves should demonstrate the courage to enact these reforms.