Tax and Fiscal Policy

Scrapping the tax-free lump sum for pension withdrawal: not such a terrible idea

In an article in the Times earlier this week I suggested Sajid Javid take a bold approach to tax reform. I argued that we should strive for lower and simpler taxes. On its own, the former would probably make our tax system less progressive overall, while the latter would make it more progressive.

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.


Director General, IEA

Mark Littlewood is Director General of the Institute of Economic Affairs and the IEA’s Ralph Harris Fellow. Mark has overseen significant growth in the IEA’s size, influence and media profile during his tenure, since 2009. Mark also sits on the Board of Big Brother Watch, a non-profit organisation fighting for the protection of privacy and civil liberties in the UK. Mark is recognised as a powerful, engaging and articulate spokesman for free markets. He is a much sought-after speaker at a range of events including university debates, industry conferences and public policy events. He also features as a regular guest on flagship political programmes such as BBC Question Time, Newsnight, Sky News and the Today Programme. He writes a regular column for The Times and features in many other print and broadcast media such as The Telegraph, City AM and Any Questions.

8 thoughts on “Scrapping the tax-free lump sum for pension withdrawal: not such a terrible idea”

  1. Posted 09/10/2019 at 21:25 | Permalink

    Far better to first level the playing field between final salary, defined benefit and defined contribution schemes. They should all be valued on the same basis i.e. what will that income scheme cost me if purchased from a basket of providers. Most DCS members know a public sector pension scheme would cost well in excess of the lifetime allowance if purchased privately. Before you start fussing about the comparatively minor sums taken tax free from private schemes, look at the costs of the public sector schemes and how much taxation they account for.

  2. Posted 10/10/2019 at 16:07 | Permalink

    Hi Mark,

    Interesting blog – as the person who suggested your idea was “terrible” I should probably respond!

    I think you vastly underestimate the impact scrapping the tax-free lump sum would have on people’s behaviour. I speak to lots of ordinary investors as part of my job and the provision of a tax-free lump sum is one of the biggest factors cited by non-experts in putting money aside for their retirement.

    Given automatic enrolment has just been fully introduced, with opt-out rates relatively low, now would seem an odd time to remove such an important and popular feature of the pension system. To do so would risk undermining the entire programme, potentially driving significant opt-outs and effectively taking us back to square one. If you have evidence suggesting auto-enrolment or average contribution rates more broadly – which are already pitifully low – would not be negatively affected by ditching tax-free cash, i’d be interested in seeing it.

    I share your desire for simplification where possible and agree the taper for higher earners should be done away with. Given this raises around £1bn a year – a very small amount in public sending terms – I suspect there are less damaging ways to find that cash.

    There is also a risk your proposal would make pensions taxation even more unwieldy. People who have built up pension savings to date would, presumably, be entitled to 25% tax-free cash on the money they have saved under your proposal? After all, it is possible for many people the promise of 25% tax-free cash at 55 was a primary reason they contributed.

    Creating a system to account for this would be highly complex, while failing to do so would be grossly unfair.

    Feel free to drop me an email if you want to discuss further.



  3. Posted 11/10/2019 at 15:23 | Permalink

    While I agree in principle, I think a more pragmatic approach would be to limit the TFC to a fixed amount (e.g £50,000), which would limit the costs which hopefully would allow the simplifications elsewhere.

  4. Posted 11/12/2019 at 20:33 | Permalink

    Totally outrageous to dangle a carrot for someone who has paid in for 40yrs then at the flick of a pen remove the promise of a 25% tax free sum in the last year. Fine to start a system for new pensions then people can choose for future what to do with their money

  5. Posted 16/04/2021 at 11:01 | Permalink

    As a person who has just had there 25% after saving for 40 years and getting the so called tax allowance I was then adviced to put it in to a drawdown. As I have a private pension and will be getting my state pension this year 2021 I have found out that anything I draw out if my drawdown will be tax at 20%. When you take 8nto account how much tax relief I got while saving and how much tax I will pay trying to get my money back far out ways what tax relief I got while saving. So I would never advise anyone to invest as I did as you will only get stung when you try to get it back unless you can stay under you tax allowance.

  6. Posted 21/05/2021 at 09:26 | Permalink

    Stuart (saver)
    You got tax relief at the point of contributing, and you used up your 25% tax relief in one hit.
    Did you expect a 3rd round of tax relief?
    You could have had only 75% exposure to income tax, by using it frugally. You could have crystallised at a different rate and paid tax on 50%, or spread it by taking only part of the lump sum. Your knowledge was at fault, not the system.

  7. Posted 14/09/2021 at 20:20 | Permalink

    A far better idea for the simplification of pensions would be to have a single rate of tax relief. At the moment the rules benefit the wealthy so moving to a single rate of 20% would even things out and increase the tax take to fund the NHS.

  8. Posted 24/08/2022 at 06:33 | Permalink

    Why not just take away tax relief on payments made into your pension so you pay tax upfront. Then any pension drawdown made in later life make tax free. Simple, much easier to administer and fair.

Leave a Reply

Your email address will not be published. Required fields are marked *