In July, Chancellor of the Exchequer Rachel Reeves came out firing on all cylinders and boldly claimed – unusually so for any Chancellor – that public taxation is going up. In a political jousting match back and forth, Reeves and her predecessor Jeremy Hunt pointed fingers at each other disputing the veracity of Labour’s claim that a monumental £22bn black hole had been left in public finances.
Labour’s commitment to “not taxing working people” has led to income, national insurance and VAT being shielded from any potential tax increases. Given that these avenues constitute around £627bn of public taxation, raising £22bn becomes a challenging task with few other options available in order to boost public finances.
Consequently pensions have come under the microscope ahead of the Autumn budget in October. There are few ways in which Labour could revise pension rules, one of which is reconsidering the tax-free lump sum, otherwise known as the Pension Commencement Lump Sum, or the PCLS. A few political commentators have speculated that it could be reduced to a fixed percentage of the overall value of the pension, or set monetary value like it currently is now (£268,275, which is a quarter of the previous – and now abolished – lifetime allowance).
All this leaves pension savers uncertain on their retirement plans, with many above minimum retirement age looking to potentially take their 25% tax-free cash ahead of any potential changes. This article will look to set out the strengths of pensions in the event that such changes come into effect, as well as outlining key information which can offer you a platform to make more of an informed decision when it comes to planning your retirement.
Tax wrappers are gold dust in a tough fiscal climate
Firstly, an often overlooked benefit of a pension is that all capital gains, dividends, and interest earned as income grow completely tax free within a tax wrapper, like the self-invested personal pension (SIPP) we have at Moneyfarm. One of our previous articles goes into this in greater depth, but the fact remains that if you take your tax-free cash early and in contradiction to your retirement requirements, it may leave you with unintended consequences and a high-tax bill.
Capital gains tax is another area thought to be amended in the Autumn budget. The allowance sits at a decades low of £3,000, whilst capital gains rates are thought to increase to match those of current income tax bandings.
To see how the mechanics of taking an early PCLS would work using the assumed changes to capital gains tax, I’ll run through a few various scenarios. Sharon, 55, is in full time employment and earns £60,000 each year across a 5 year period. She is in the higher rate tax bracket, meets the minimum pension age criteria, which has a total value of £480,000. If she were to access her tax-free cash at 55 she would have £120,000 available to her, with her intended work retirement age being 67.
Example of going to cash
Sharon could put £20,000 into a cash Individual Savings Account (ISA) immediately, potentially earning 4.55% each year, with the remaining value being allocated to a savings account potentially earning 5% each year. Each new tax year an additional £20,000 could cross into the cash ISA. Anything held in the savings account would be charged at 40% tax on the interest earned every tax year.
At the end of the five-year period, Sharon could earn £32,907 as interest but will need to pay £5,962 as tax, leaving her with £26,945.
Example of going to stocks and shares
Similarly Sharon will utilise her ISA allowance each year, using a General Investment Account for the remaining capital. The returns will have an assumed capital gains growth mirroring a simplified calculation using the last 5 complete years for our risk level 5 of 7 (2019-2023). Capital at risk and past performance is not an indicator of future returns. Capital gains is charged at 40%, in line with the expected changes to the capital gains tax rates.
At the end of the five year period, Sharon will have returned £36,731* but will need to pay £7,676 as tax, leaving her with £29,056.
People who take their 25% tax-free lump sum and adopt similar strategies to those listed above may have more significant and regular tax bills to HMRC along the way, which could eat into their disposable income in a given tax year. By keeping it in a pension, all growth through capital gains, dividends and interest are completely shielded from tax and frees up disposable income in the short term.
Remember – Keir Starmer has indicated that the fiscal changes will be “short-term pain” for “long-term gain”. In the example above Sharon is retiring at 67, 12 years from when she has access to the pension. Not only is this a significant period of investment growth within a tax wrapper, but also the fiscal outlook could look very different in 12 years time.
*Assumed capital gains in each year:
- Year 1: £14,600
- Year 2: £4,635
- Year 3: £8,954
- Year 4: -£7,842 (allowable loss)
- Year 5: £4,156 (no chargeable gain – covered by the previous year’s allowable loss)
The returns here are simulated using an assumed balance of £250,000, and the average management fee from our pricing model of 0.46% from 01/01/2016 to 31/10/2017, 0.55% from 01/11/2017 to 28/02/2020, 0.44% from 01/01/2020 – 31/05/2022, and 0.40% from 01/06/2022 – 01/07/2023. The returns are also net of management fees, underlying fund costs, and market spread. The returns are the total returns, so include all dividends. (Data Source: Bloomberg/xignite) Past performance and simulated past performance are not a reliable indicator of future performance.
Don’t change the course of your financial plan
It’s also vitally important to stick to your financial goals when making a significant decision such as this. For example, taking the tax-free cash from your pension and not using the funds in line with any of your life plans can impact the growth you see on your investable assets.
Despite being in a relatively high interest environment, considering the past 15 years, the real (adjusted for inflation) return of cash is often negative. In the event you should wish to take funds out of your pension then the allocation of newly accessed cash should reflect your goals.
It may well be the case that you tick off some essential or less essential short-term objectives with those funds, but if your saving time horizon is long-term then over an extended period of time an investment portfolio has a statistically higher probability of seeing a greater return than cash. The extent to which will naturally depend on the length of the investment period, tolerance and appetite for risk, among other factors, including placing capital at risk. This is something we can go through together, just book an appointment here.
Be resistant to any knee-jerk decisions
As ever, it’s always best practice to seek professional guidance to go over your specific situation and requirements. Taking the tax-free sum is an irreversible process where you can move from a tax efficient vehicle to a non-tax efficient environment. So making an informed decision with all the facts at hand is better than one where decisions are made based on an emotional reaction to unknown factors.
One of the most notable things to add on this subject is that there are huge complexities in enforcing any new rule changes to the tax-free lump sum and changes would unlikely be enforced overnight. Pension providers would not be able to implement the changes without fair warning, as work would need to be done to update internal systems. More importantly though, it would completely dismantle any carefully designed plans for those who have prepared for retirement early.
It’s widely considered that this would be a greatly unpopular decision to be implemented by Labour. Pension rules are notoriously complicated and convoluted, so removing one of the simple and effective rules could be very politically damaging. To that – slightly more comforting – end, a Labour spokesperson, quickly dispelling assertions by Starmer that the party would change rules on the tax-free allowance, said: “The ability to withdraw 25 per cent of your pension as a tax-free lump sum is a permanent feature of the tax system and Labour are not planning to change this”.
As with any legislation, nothing is set in stone forever. But anyone concerned about any potential changes should take comfort in the fact that changes are most likely not to be implemented overnight, if at all. Even if they are, the pension still remains a strong and favourable investment vehicle due to its tax advantages in a challenging fiscal environment.
As with all investing, financial instruments involve inherent risks, including loss of capital, market fluctuations and liquidity risk. It is important to consider your risk tolerance and investment objectives before proceeding. A pension may not be right for everyone. Tax treatment depends on your individual circumstances and may be subject to change in the future. This information is for educational purposes only and should not be considered as personalised investment advice. If you are unsure if a pension is right for you, please seek financial advice.
Peter Rice is an Investment Adviser at Moneyfarm having joined in October 2021 as a Junior Investment Consultant. Having held numerous client-facing roles over a span of many years, he currently helps customers achieve their financial goals, conducts portfolio reviews, and provides assistance in the creation of content pieces for the company. Peter holds the Investment Advice Diploma with the CISI, as well as an MA in International Business Management from Heriot-Watt University and a MSc in Finance from the University of Edinburgh.
*Capital at risk. Tax treatment depends on your individual circumstances and may be subject to change in the future.
