Speculation about the upcoming budget is in full force. One rumour that stands out is around possible changes to tax-free cash withdrawals for pensions.
Record amounts of tax-free cash have been withdrawn from pensions since August 2024. This could be due to known pension reforms…we already know that unused pensions will become subject to Inheritance Tax (IHT) with effect from April 2027. Or maybe the rumours about capping tax-free cash amounts are influencing people to act now.
The speculation is that the tax-free lump sum withdrawal amount could reduce to £100,000 or even as low as £40,000.
Normally, 25% of a pension pot can be taken tax-free. This is limited to a lifetime cap, known now as the Lump Sum Allowance (LSA), which is usually £268,275 but can be higher for those with protected allowances. Pension withdrawals not within the tax-free amount are taxed at marginal rate.
So, what would be a fair amount to land on?
If the cap is £40,000 then perhaps this is a step too far as the impact would be significant. So, is £100,000 the fairer number?
Example scenario: Meet Anne
Let’s look at the situation for Anne, a nurse, grade 6 (England & Wales), with a salary of £50,000 and who has been a member of the NHS pension scheme for 30 years. How would a cap of £100,000 affect her?
Under the 2015 career average scheme with 30 years’ service, Anne would have a final salary pension of approximately £24,000 - £27,000. If she exchanged some of this for a tax-free lump sum and receives £12 of lump sum for every £1 of pension she gives up (known as pension commutation), she would end up with a tax-free lump sum of between £102,000 - £115,000.
She would therefore not be immune if a cap of £100,000 was implemented as she will either be limited to a lump sum of £100,000 or the excess above £100,000 would be subject to income tax.
It’s no wonder then, that the financial press is reporting a 61% increase in tax-free cash withdrawals since last year. The government might be fine with this uptick if the proceeds are being spent and moving the economy overall. It could help them raise valuable tax revenue. But the economy is sluggish and both the government and the FCA have recently issued warnings against acting rashly in withdrawing tax-free cash. Clearly, it’s not going their way, so has this particular government kite been struck by lightning?
It’s not just the rich who would be impacted by a change like this.
More public and private sector workers would be subject to income tax on the lump sum amounts taken above the cap. There would be more pressure on pension scheme administrators to calculate and pay this tax before any lump sums are paid. System updates would also be needed.
So, there may well be an announcement about a review on tax-free cash limits, with a consultation to iron out how it’s all going to work, and when it might happen. With all of the changes required, it would be a big ask to align it with the 2027 pension and IHT changes. If it’s left longer than that, then it starts to creep closer to election-time and it’s unlikely that this type of policy would be a vote-winner.
Here’s what we do know:
- Draft legislation on reforming IHT to include unused pension funds and death benefits was issued on 21 July 2025.
- The policy paper on this confirmed that the estimated revenue and impact reports didn’t account for behavioural changes.
- A behavioural response such as tax planning or drawing down pension funds faster, was to be expected
We’ve seen that there has been a behavioural response as tax-free cash withdrawals have increased. So, where is the money going if it’s not being spent?
Maybe it’s being legitimately used for IHT and trust planning.
Using trusts to protect a client's estate from inheritance tax can be really beneficial, but a lot of clients don't like the idea of locking their money away and giving up access for themselves. So, it’s worth considering a trust or combination of trusts that strikes a balance between IHT efficiency, control and access.
If you have any questions or would like to understand how potential changes announced in the Autumn Budget could affect your clients, get in touch with our team by emailing wealth.sales@canadalife.co.uk
Additional Resources
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Learn more about how our Flexible Reversionary Trust, the Wealth Preservation Account, could potentially reduce your clients' IHT liability while still giving them access to the trust assets.
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Sources:
NHS Pensions - 2015 Members Guide
HMRC Pensions Tax Manual
Tax-free cash and the 'lump sum allowance' (LSA)
Inheritance Tax on unused pension funds and death benefits
Reforming Inheritance Tax — unused pension funds and death benefits
Weird Laws in the UK: Bizarre UK Laws