The fiscal black hole that needs to be plugged by the chancellor, Rachel Reeves, is growing and a tax raid on pensions is on the agenda to help fill it.
Heavy hints coming from the government suggest that two key tax changes could be on the hitlist, which would affect millions of savers and their retirement pots.
The deputy prime minister, Angela Rayner, is lobbying for the controversial lifetime allowance — which capped how much could be saved into a pension without triggering hefty tax charges — to be reinstated. The government is also considering reforms to salary sacrifice schemes, a tax-efficient way used by millions of workers to pay more into their pension, including reducing the tax relief on employee and employer contributions.
It comes after a U-turn by the prime minister on the means-testing of winter fuel payments for pensioners, which will be an expensive move for the government and add pressure on Reeves to find alternative sources of revenue.
There is growing concern that a tax raid on pensions will feature in the chancellor’s autumn budget this year, while financial advisers have been swamped with calls from worried clients concerned about the constant changes to pension rules.
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Steve Webb, the former pensions minister and a partner at the consultancy LCP, said: “With the government still committed to not raising headline rates of income tax, national insurance or VAT but facing a looming fiscal black hole, there can be no doubt that raising revenue through changes to tax breaks on pensions will be on lists of options circulating in the Treasury”.
Here’s what a tax raid on your pension could look like, and how you could beat it.
Is the lifetime allowance coming back?
A leaked memo has shown that Angela Rayner is in favour of bringing back the lifetime allowance on pensions, which was effectively scrapped by the Conservative government in April 2023, then officially removed last year. The rule had capped the amount you could save into a pension over a lifetime at £1,073,100. Anything over that amount risked a penalty of up to 55 per cent.
The charge could reach 55 per cent of any amount above the allowance if it was withdrawn as a lump sum, or a 25 per cent charge on top of your income tax rate if taken as income.
The lifetime allowance has been changed a lot since it was first introduced in 2006-2007 at a cap of £1.5 million. Its highest level was £1.8 million in 2010-2011 and it was as low as £1 million in 2016-2017, rising to £1,073,100 before the charge was scrapped in 2023.
In 2023 the government estimated scrapping the lifetime allowance would cost about £2.4 billion between April this year and April 2028.
Each time the lifetime allowance was cut, the government introduced protection for those who were already over the limit, allowing them to have pensions worth more than the allowance without incurring a penalty. Such protections would probably be made available again.
Webb said: “Without this, people could face a form of retrospective taxation in that they would be charged for being above a limit that didn’t exist when they were adding to their pension.”
As any changes are still speculation, advisers urge caution. Helen Morrissey from the investment platform Hargreaves Lansdown said: “It’s important that people do not make knee-jerk reactions to rumours as this risks them making decisions they later come to regret.
“It is always best to continue planning within the present system. If change is to happen then the likelihood would be that a protection system would come into play, as happened when the lifetime allowance was reduced in the past.”
Any changes are unlikely to happen quickly — although the charge was removed immediately it has taken nearly two years fully abolish the lifetime allowance. It was announced in spring 2023, but the HMRC regulations were finalised at the start of this year. “It’s hard to imagine that reintroduction would be any less complex,” Webb said.
Who would be affected?
LCP estimates that 4-6 per cent of those aged 55-64 — about 250,000 people — have benefited from scrapping the allowance.
Those with large defined benefit (DB) pensions, which pay a guaranteed income in retirement, make up the majority of the people who are likely to be affected, including high-ranking public sector workers.
One reason the previous government scrapped the lifetime allowance was to stop senior NHS consultants from retiring early as they were among those who were likely to breach the cap.
Webb said: “There might need to be ‘something for the doctors’ — in particular to avoid the risk of consultants with large DB pensions deciding to avoid lifetime allowance charges by retiring. This would be most unwelcome to the government’s wider agenda.”
But exempting certain workers may cause its own problems. Jon Greer from the investment firm Quilter said: “If the government were to carve out public sector workers, the result would be a pension tax system perceived by some as unprincipled and unfair. Favouring certain careers over others sets a dangerous precedent, distinguishing public-sector wealth as ‘good’ and private-sector wealth as ‘bad’.”
Laith Khalaf from the investment platform AJ Bell said: “Bringing back the lifetime allowance for pensions would be a big step backwards. It would cause confusion and make saving for retirement more complicated. Since we already control how much you can pay into a pension each year, this allowance effectively taxes how well you invest your pension and the risks you take.”
The Treasury was approached for comment.
Is salary sacrifice at risk?
Salary sacrifice allows you to make pension contributions or pay for other benefits such as company cars, bicycles or medical insurance from your gross salary before income tax is taken.
This “sacrifice” of some of your salary means that your income is lower and so you pay less tax and national insurance. Your employer also has to pay national insurance on the wages that it pays you, so if they are lower through salary sacrifice, your employer will also pay less.
Most large companies offer these schemes, and they have become even more popular since employer national insurance went up in April.
Reeves’s biggest change in the budget last October was to increase the national insurance rate for employers from 13.8 per cent to 15 per cent. The threshold at which companies start to pay national insurance on an employee’s salary was also reduced from £9,100 a year to £5,000.
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The government said it consulted 51 firms, 41 of which offered salary sacrifice, on three proposed changes to the scheme.
One proposal, removing both income tax and national insurance relief, would cost an employee earning £35,000 and contributing 5 per cent to their pension through salary sacrifice £560 a year, and their employer an additional £241.
A second option, eliminating only national insurance relief, would cost the employee £210 and the employer £241 a year.
The third option, removing national insurance relief on amounts sacrificed above £2,000, wouldn’t cost someone earning £35,000 and sacrificing 5 per cent any more, but it would cost someone earning £45,000, £30 a year and their employer £34.
Employers opposed all options.
Kate Smith from the pensions firm Aegon said: “Any move to reduce or remove the benefits of salary sacrifice would be a blow to both employers and pension savers. While no policy changes have been confirmed, the release of this research has intensified scrutiny ahead of the budget.”
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Salary sacrifice is particularly attractive for parents who start to lose their child benefit when their income hits £60,000 or for those earning between £100,000 and £125,000 as they lose their personal allowance and some childcare support. By sacrificing some of their salary to put more into a pension, they can keep more of their child support and personal allowance.
Greer said: “Any restriction on salary sacrifice would probably be deeply unpopular, particularly given that income tax thresholds have been frozen for years, pushing more people into higher tax brackets. If reforms are pursued, millions of workers could be affected — in some scenarios, people on average incomes could lose around £500 a year in extra tax and national insurance contributions.”
