Treasury officials are reportedly looking at cutting the tax-free lump sum to as little as £40,000
Rachel Reeves is reportedly weighing up a cut to the tax-free lump sum pensioners can take at retirement, in a move that could raise billions for the Treasury but trigger a backlash among savers.
The Chancellor has been presented with the option of reducing the maximum tax-free withdrawal from £268,000 to as little as £40,000, as she looks for ways to fill the gap in the public finances, according to The Daily Telegraph.
While Treasury officials have stressed that pension reform is “unlikely” to be a priority in this autumn’s Budget, industry figures believe it may prove too tempting to ignore given the need to raise money for the public purse.
How the system works now
At present, pension holders can withdraw up to 25 per cent of their retirement savings tax-free, capped at £268,275.
This arrangement has been central to the pension system since the abolition of the lifetime allowance in 2023, with many savers benefitting from the ability to take a quarter of their pension pot upfront upon retirement.
The current rules mean someone with a pension pot worth £400,000 could take £100,000 tax-free, while a person with £1m could withdraw the maximum of £268,000 without incurring tax.
Anything above those thresholds is taxed in line with the individual’s marginal income tax rate when accessed.
What Reeves is considering
The Chancellor is understood to be looking at several options. One is to reduce the cap from its present £268,000 to £100,000, a level that the Institute for Fiscal Studies has previously floated.
Another more radical proposal is to set the maximum at just £40,000, an idea that pensions minister Torsten Bell has supported in the past.
Pensions and treasury minister Torsten Bell (Photo: Jordan Pettitt/PA Wire)
Before the 2024 Budget, Treasury officials even reportedly asked a leading pension provider to model the effects of a £100,000 cap.
Reeves ultimately opted against it, preferring to raise national insurance employer contributions instead. But with the public finance gap now estimated by the National Institute of Economic and Social Research (NIESR) at more than £50bn, speculation has intensified that she may return to the policy.
How much money could it raise?
The Institute for Fiscal Studies has estimated that reducing the tax-free cash allowance to £100,000 could save the Treasury around £2bn a year once entirely in effect.
A deeper cut to £40,000 could deliver more, though the impact of these gains would build more gradually.
This is because pension lump sums are typically taken at retirement, meaning the full revenue impact would take years to materialise. For a Chancellor facing an immediate shortfall, that timing issue could reduce the attractiveness of the measure.
Smith noted that restricting the pension commencement lump sum (PCLS) “would not bring in extra revenue for the Government swiftly, it would be a long-term gain, so that could make this a less attractive move given how unpopular it would be”.
Who would be affected?
A reduction in the cap would hit those with larger pension savings hardest. If the maximum were lowered to £100,000, anyone with a pot exceeding £400,000 would see their tax-free entitlement curtailed. A £40,000 cap would bite at just £160,000.
For someone with a pension pot of £500,000, the difference would be significant. Under the current rules, they can take 25 per cent – or £125,000 – tax-free. If the cap were reduced to £100,000, their tax-free entitlement would shrink by £25,000, leaving that portion to be taxed at their marginal rate. For a higher-rate taxpayer, that would mean around £10,000 more going to the Treasury.
A sharper cut to £40,000 would reduce their tax-free entitlement by £85,000 compared with today. Assuming a higher-rate taxpayer, that translates into roughly £34,000 of additional tax collected throughout retirement.
The effect is even more pronounced for those with larger savings. Someone with a £1m pension pot currently qualifies for the maximum £268,275 tax-free. A £100,000 cap would strip away £168,000 of that entitlement, while a £40,000 cap would see more than £228,000 subjected to income tax.
This would affect higher earners in both the private and public sectors, including professionals in defined benefit schemes such as doctors, senior civil servants and academics. Transitional protections could be offered, as happened when the lifetime allowance was reduced in the past. But even with safeguards, any cut could alter incentives for long-term saving, potentially discouraging people from building larger pension pots.
Why pensions are in the firing line
Reeves has pledged not to raise income tax, VAT or employee national insurance, leaving her with limited levers to pull. That makes pension reliefs a prominent candidate for reform, since they are costly to the Exchequer and skewed towards higher earners.
Stephen Millard, deputy director at NIESR, told The i Paper last week that Reeves could need to raise more than £40bn and “may also look at taxing pension wealth” in the autumn Budget.
HMRC figures show that total tax reliefs on pensions, including both income tax and national insurance, cost £78.2bn in 2023–24.
That cost, coupled with the fact that the most generous benefits accrue to higher and additional-rate taxpayers, has fuelled arguments that the system is inequitable.
Cutting the tax-free lump sum cap could be seen as one of the most straightforward ways to reduce the generosity of the regime.