The growing fiscal deficit that Chancellor Rachel Reeves needs to address is raising alarms, with potential tax alterations on pensions being considered as a means to close this gap.

Government officials have hinted that two significant tax adjustments may be under consideration, potentially impacting millions of savers and their retirement funds.

Deputy Prime Minister Angela Rayner is advocating for the controversial reintroduction of the lifetime allowance, a cap on pension savings that triggers substantial tax penalties for exceeding the limit. Additionally, the government is evaluating potential reforms to salary sacrifice arrangements, a popular tax-efficient method employed by numerous workers to boost their pension savings, which may include reducing tax relief on both employee and employer contributions.

This discussion follows a reversal by the Prime Minister on the means-testing criteria for winter fuel payments to pensioners, a move that will impose significant costs and exacerbate Reeves’s challenges in finding alternative revenue sources.

There is rising apprehension that the upcoming autumn budget may include a pension tax raid, prompting financial advisors to receive an influx of inquiries from anxious clients about the ongoing shifts in pension regulations.

Steve Webb, a former pensions minister and partner at the consultancy LCP, noted, “Given the government’s commitment to avoid raising the standard rates of income tax, national insurance, or VAT, yet facing a significant fiscal deficit, it is clear that raising revenue through modifications to pension tax breaks will be among the options discussed within the Treasury.”

This article explores what a potential tax raid on your pension might entail and how you can mitigate its effects.

Will the Lifetime Allowance Return?

A leaked memo indicates Angela Rayner supports reinstating the lifetime allowance on pensions, a rule that was effectively abolished by the Conservative government in April 2023. Previously, this allowance capped lifetime pension savings at £1,073,100, with penalties of up to 55% for exceeding this amount.

Such penalties could range from 55% on any lump sum exceeding the allowance, or a 25% charge on top of the individual’s income tax rate if taken as regular income.

The lifetime allowance has undergone numerous revisions since its implementation in 2006-2007, starting with a £1.5 million cap. It reached a peak of £1.8 million in 2010-2011 but dropped to as low as £1 million in 2016-2017 before being set at £1,073,100 prior to its abolition in 2023.

In 2023, the government projected that eliminating the lifetime allowance would result in a cost of around £2.4 billion between April this year and April 2028.

Each time the allowance was reduced, protections were introduced for those exceeding the limit, permitting them to maintain pension values exceeding the cap without incurring penalties. Similar protections are likely to be reinstated.

Webb cautioned, “Without such provisions, individuals could face retrospective taxation, being penalized for exceeding a limit that did not exist when they were contributing to their pensions.”

As these speculations unfold, financial advisors advise caution. Helen Morrissey from Hargreaves Lansdown urged, “It’s crucial for individuals not to react impulsively to rumors, as this could lead to regrettable decisions. It is always wise to continue planning based on the current system. If changes do occur, protections will likely be established, akin to past instances of changes to the lifetime allowance.”

Any remapping of the rules is unlikely to transpire swiftly; though the charge was revoked immediately, it took nearly two years for the lifetime allowance to be fully abolished. Announced in spring 2023, HMRC regulations were not finalized until early this year. Webb remarked, “It’s hard to expect that reintroducing this allowance would be any less complicated.”

Who Will Be Affected?

LCP estimates that between 4% to 6% of people aged 55-64—about 250,000 individuals—have gained from the removal of the allowance.

Individuals with substantial defined benefit (DB) pensions, which promise a guaranteed income in retirement, predominantly comprise those most likely to be impacted, including senior public sector employees.

One reason the prior government abolished the lifetime allowance was to prevent senior NHS consultants from retiring early, as they often found themselves breaching the cap.

Webb commented, “There may need to be consideration for doctors, particularly to mitigate the risk of consultants with large DB pensions opting to retire to evade lifetime allowance penalties, which would be detrimental to the broader governmental agenda.”

However, creating exemptions for specific workers could lead to its own challenges. Jon Greer from Quilter remarked, “If the government were to exempt public sector employees, it could create perceptions of an unjust pension tax system, favoring some careers while disadvantaging others, setting a precarious precedent regarding wealth classification.”

Laith Khalaf from AJ Bell added, “Reinstating the lifetime allowance for pensions would represent a significant regression. It would contribute to confusion and complicate retirement savings, especially since the government already regulates the contributions to pensions each year, effectively taxing investment success and the risks taken.”

The Treasury was contacted for further comments.

Is Salary Sacrifice Under Threat?

Salary sacrifice arrangements allow employees to make pension contributions or pay for other benefits like company cars, bicycles, or medical insurance from their gross salary before income tax deductions.

This “sacrifice” reduces the employee’s reported income, leading to lower tax and national insurance obligations. Employers benefit as they pay national insurance based on reduced wages, leading to additional savings.

Most large companies offer salary sacrifice schemes, which have surged in popularity since national insurance rates for employers increased in April.

Reeves’s most consequential budget change last October raised the employer’s national insurance rate from 13.8% to 15%, while decreasing the threshold for national insurance payments on employee salaries from £9,100 to £5,000.

The government consulted with 51 companies, 41 of which provided salary sacrifice schemes, on three proposed changes to these arrangements.

One proposal aims to eliminate both income tax and national insurance relief, potentially costing an employee earning £35,000 and contributing 5% to their pension via salary sacrifice an additional £560 annually, alongside an extra £241 for their employer.

Another option would remove only the national insurance relief, costing the employee approximately £210 and the employer an additional £241 yearly.

The third approach, which would remove national insurance relief for amounts sacrificed over £2,000, would not affect someone earning £35,000 and sacrificing 5%, but would impose an additional cost of £30 annually on someone making £45,000, along with £34 for their employer.

Employers have expressed opposition to all proposed changes.

Kate Smith from Aegon stated, “Any steps to diminish or eliminate salary sacrifice advantages would significantly impact both employers and pension savers. Although no official policy shifts have been confirmed, the release of this research has intensified scrutiny ahead of the upcoming budget.”

Salary sacrifice is particularly appealing for parents who stand to lose their child benefit as their income exceeds £60,000 or those earning between £100,000 and £125,000 who risk losing their personal allowance and certain childcare support. Opting to sacrifice some salary to increase pension contributions can allow them to retain more of their child benefit and personal allowance.

Greer remarked, “Any limitations on salary sacrifice would likely be profoundly unpopular, especially with income tax thresholds being stagnant for years, thereby pushing more individuals into higher tax brackets. If these reforms move forward, millions of workers could be impacted, with average earners potentially facing an extra £500 in tax and national insurance contributions annually.”