Scrapping the tax-free lump sum for pension withdrawal: not such a terrible idea
Because the tax system is so progressive, with high earners paying a much higher proportion of the total take than a generation ago, tax reductions would be likely to benefit wealthier demographics disproportionately. However, the simplification of the tax system would very likely offset this to a considerable degree. The tax code has exploded in length and a fair chunk of this growth has been the design of ever more complex deduction schemes which are typically used by the affluent.
Politicians have tended to make the headline tax rates higher on wealthier groups while simultaneously supporting a swathe of wizard wheezes by which the affluent can actually reduce their tax liabilities.
An example I gave was to abolish the tax-free lump sum you can take out of your pension. The essential purpose behind saving for a pension is to seek to smooth your income over your lifetime. While you are earning well today, put aside some money to use for when you get older and exit the labour market.
To take an extreme example, if you’re a Premier League footballer, you may be earning millions of pounds in your twenties, but you are unlikely to reach these heights when you are in your late thirties or older. It would therefore be prudent to tuck away a substantial slice of cash while you are actually playing for Manchester United to be used at a later date.
The easiest and simplest system would be to essentially defer the tax on this saving until you draw it down. You should be able to put as much into your pension as you wish and simply face the same tax liability as everyone else when you draw it down. If you withdraw a modest amount, you’ll be taxed at the basic rate. If you draw down a large amount, you’ll face higher rates. We should treat pensions, when claimed, and salaries, when paid, in exactly the same way.
At present, the system allows you to draw down up to a quarter of your pension pot from the age of 55 in a low tax fashion. But this benefit is combined with a vast swathe of rules, regulations and taper rates which make the pensions system largely impenetrable to those who don’t actually work in the industry. Some of those who do have labelled my suggestion “a terrible idea” (see here and here).
But what I am no longer giving with one hand, I will cease to take with the other. There is no reason to believe my overall plan would deter savings – in fact, I would end all taper rates on paying into your pension, thereby encouraging earners to put more aside.
The tax-free lump sum is an anomaly which mainly benefits better-off people. It allows people to put money into a pension fund and receive tax relief and not pay any tax when the money is withdrawn (whether that is done formally through a defined contribution scheme or is part of the benefit package in a defined benefit scheme).
It is also the only obvious anomaly in the pension fund tax system which, in other respects, is just a tax-deferral and income-smoothing mechanism. The Treasury responds to this with large volumes of regulation to limit pension saving which also affect work incentives (a topical example being GPs).
Such regulation could be removed if the anomaly were removed. The tax-free lump sum sits awkwardly with pensions freedom and there is yet another set of regulations designed to prevent people putting money into a pension fund, claiming tax relief and then immediately withdrawing it tax free. Regulation upon regulation is the result.