Will pension tax-free lump sums be scrapped?

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A think tank has proposed a radical rethink of pensions. Instead of different tax relief for different people, it has called for 33% tax relief for everyone - and has also suggested that you shouldn't be able to take a penny as a tax-free lump sum when you retire.

But will it happen?

Proposals

Michael Johnson from The Centre for Policy Studies made the suggestion as part of his research into how to make pensions tax relief fairer. At the moment, you receive a different level of tax relief depending on the level of tax you pay. It means that in order to add £1 to their pensions pot, a basic-rate taxpayer has to put in 80p (and the government uses tax relief to top it up to £1), while a higher rate taxpayer has to pay in just 60p, and an additional rate taxpayer has to put in 55p.

Johnson highlighted that this process cost the government £54 billion last year, are said it was "an ineffective, and inequitable, use of Treasury funds." The think tank has suggested that a fairer solution would be to give everyone 50p when they invest £1 - which is the equivalent of 33% tax relief for everyone. It's a more generous deal for basic-rate taxers, but would leave higher earners worse off.

Johnson also said that the 25% tax-free lump sum should be axed. He argued that the tax-free lump sum was an ineffective way to try to tempt people to save and that with the new freedoms introduced to pensions it no longer made any sense.

And he added that the annual amount that can be saved into a pension ought to be reduced, to stop wealthier people paying in tens of thousands of pounds a year and getting the lion's share of the tax-savings from pension investments. He suggested a combined pension and ISA annual cap of £30,000. This would remove the need for a lifetime allowance.

Will it happen?

The level of tax relief on pensions is a hot topic in Westminster. Last week pensions minister Steve Webb indicated that he was considering setting tax relief for everyone at 30p - and removing the lifetime allowance for savings.

Tom McPhail, head of pensions research at Hargreaves Lansdown, said tax relief was bound to come under scrutiny as a result of the changes to pensions that were announced in the Budget.

He is not convinced that the think tank's proposals will be implemented. He points out that those implementing reforms will have three key objectives: to encourage people to save more for retirement, and to make the system fairer on those on lower incomes - without costing the government anything in the process.

He adds: "In this context, the proposals look perhaps overly intricate. We don't think this is a good moment to start attacking the tax free lump sum entitlement. Similarly the proposal for a combined ISA/Pension allowance of £30,000 looks quite restrictive, compared to today's twin allowances amounting to £55,000."

Instead he prefers Webb's suggestion - particularly the removal of the lifetime allowance, as it brings needless complexity to pensions and it puts people off saving. However, he says the experts are a long way from reaching consensus on the best approach, pointing out that: " Any changes need to be demonstrably more effective than the present set of reliefs. More work needs to be done to examine the behavioural impact of any changes, in order to ascertain what effect they would have on people's propensity to save. This is something we will be exploring further in the months to come."

The think tank's proposals are therefore unlikely to come to fruition exactly as suggested. However, the very fact that they are wading into the debate indicates the growing pressure for change - which means yet another significant reform of the system is on the cards.