The Institute of Economic Affairs (IEA) has urged the government to scrap the tax-free cash available on pensions to help pay for the abolition of inheritance tax.

Writing in The Times, IEA director-general Mark Littlewood argued that the tax system was too complicated and that a “brave chancellor must be ready to cut taxes and simplify the system”, including scrapping inheritance tax and tax-free cash from pensions.

However, AJ Bell senior analyst, Tom Selby, branded the proposal as “a terrible idea”.

“Being able to access a quarter of your pension pot tax-free from age 55 is one of the best understood benefits of saving in a pension, so ditching it altogether would have potentially disastrous long-term consequences,” he added.

“Rising average life expectancy, the increasing state pension age and the disappearance of guaranteed defined benefit provision is placing ever greater onus on individuals to provide for their own retirements.

“Given this context, public policy needs to be focused squarely on ensuring the environment encourages more pension saving, rather than pulling the rug from under people.”

Littlewood stated that, in order to simplify the system, the government should axe the 25 per cent tax-free cash available on pension savings to fund scrapping the inheritance tax.

He wrote: “There is very little to justify the tax-free lump sum people can withdraw from their pension pot. Putting an end to that carve out could, for example, go alongside reducing or eliminating inheritance tax.”

Industry experts warned that these changes would create a cliff edge for savers unless protections were introduced, and that speculation of this kind, especially about tax-free cash, could negatively affect investor behaviour and the public’s long-term confidence in pensions.

Selby continued: “There would also be severe practical issues if the government attempted to end tax-free cash for all.

“Those who had saved money on the assumption they would get 25 per cent of their final fund tax-free would justifiably feel aggrieved at an essentially retrospective tax grab.

“Even introducing a cap on tax-free cash would create a severe cliff-edge, so it is likely complex transitional measures would be needed.

“Younger savers could also justifiably argue this would represent another kick in the teeth for their retirement ambitions as they would be less able to benefit from the tax-free cash incentive than their older counterparts.

“The floating of half-baked ideas such as this is exactly the reason the government needs make a genuine attempt at bringing some certainty into pension tax policy. Savers need to feel confident that the pension tax rules won’t be changed every five minutes, which feels reasonable given we are asking them to lock their money away for decades.”

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