Industry experts warn such a move would lead to investors losing billions in tax relief. They also say it could trigger a “Northern Rock style run on money” and would do little to alleviate the budget deficit.

YourMoney.com explains the proposals and the potential impact on pension pots for basic, higher and additional rate tax payers.

What’s the current system of pension tax relief and withdrawals?

Currently, if you’re a basic rate taxpayer the government will give you £20 for every £80 you put into your pension pot. If you’re a higher rate taxpayer earning over £42,385 (this rises to £43,000 in April) the government contributes £40 for every £60 you contribute. If you’re an additional/top rate taxpayer (earning over £150,000), you pay £55 and the tax relief is £45.

Under the new pension freedoms introduced in April 2015, anyone aged 55+ can withdraw 25% of their pension pot tax free, while the rest is taxed at their current income tax rate.

What’s being hinted?

The outcome of the government’s review on pension taxation – announced during last summer’s Budget – is expected in the Budget on Wednesday 16 March.

There has been widespread speculation that George Osborne is expected to end the 40% and 45% pension tax relief rates at the Budget.

Instead, he would introduce a flat rate of tax relief, closer to 20% for all pension savers.

But last night it was reported that the Chancellor is gravitating to a reform to pension taxation based on an ISA-style system where he’d do away with tax relief altogether (not even at the basic 20% tax relief), but withdrawals would be tax free. Further, the government would offer a 20% “top up” to savers drawing their retirement income.

So rather than savers receiving tax relief on their gross income, the money in a pension ISA would come from taxed or net income and you’d receive a 20% top-up when you’re ready to retire.

How would this work?

Everyone pays tax on earnings and from their taxed income, individuals would pay into a pension ISA. The government would set an annual limit of what people could pay into the pension ISA.

This would mean a move away from a tax relief basis towards a top-up system. As an example, if the annual limit were set at £10,000 and the government offered to top it up by £2,000 (20%), it would be on the condition that you don’t withdraw the full amount until you reach retirement age.

How will this affect me?

A move away from tax relief towards a top up system isn’t good for medium or higher earners.

At the moment, you can put up to £40,000 into a pension in a tax year. Under a pension ISA system, the offer of a 20% top-up is lower than what higher and additional rate tax payers currently enjoy.

Martin Tilley of Dentons Pension Management says that even if someone puts £10,000 into a pension and the government tops it up by £5,000, this still only represents a 33% uplift, which is below the current 40% and 45% tax relief higher and additional earners enjoy.

Tom McPhail, head of retirement policy at Hargreaves Lansdown, says the offer of a 20% top up, with tax free withdrawals looks “superficially attractive”, and a change to pension taxation will involve cuts to the tax relief available.

“This is likely to be particularly bad news for anyone who becomes a higher rate taxpayer towards the end of their working careers when they are most able to catch up on their pension funding. It would mean cutting the Annual Allowance very substantially, probably down to around £10,000. It would therefore become extremely difficult for mid to high earners to build a decent retirement pot over their working lives.”

For a higher earner, it would mean exchanging 40% relief on £40,000 for 20% relief on £10,000; a loss of £14,000.

Further, McPhail says investors don’t trust politicians not to “muck around with the pension system” and the promise today would depend on a future government honouring such a move.

He says mid to high earners would increasingly look to higher-risk investments, such as Venture Capital Trusts.

Hargreaves Lansdown anticipates that employers may cut back on their workplace pension funding, limiting their contributions to the statutory minimums under auto-enrolment which would “penalise the lower paid in particular as they rely more heavily on their employer for support with their pension funding.”

What are the wider implications?

The big question for Tilley is what happens to existing pension schemes. Such a move would create two pension regimes whereby the existing system would be continued in addition to the new regime which makes planning very difficult.

For those in the old system, they may be able to move their money across to the new system. They’d have the same level of cash, but they’d have access to it now, so this yields more tax to the Treasury now, rather than over the course of drawing retirement income.

As an example, someone with a £100,000 pension pot can withdraw 25% tax free (£25,000). On the remaining £75,000, a basic 20% tax payer who draws the income in tranches over the next 5-10 years would pay a total of £15,000 tax.

If they withdraw this all in one go, they could be pushed into the higher tax bracket so while the £25,000 is tax free, they’d pay 40% tax on the remaining £75,000 – a total tax bill of £30,000.

However, with a pension ISA, if savers are allowed to move their money from the old regime to the new, it’s likely the government would introduce a “conversion tax”. Even if it’s 25%, the pension saver would pay a total tax of £25,000 on the whole £100,000 pot, so the government’s sacrificing less tax later.

As a result, it might cause people to take money out now and as many invest in the stock market, there could be a run of demand. “It’s robbing Peter to pay for Paul,” Tilley says as the government’s giving up future income to get it now.

This view is shared by McPhail who says tax free withdrawals would create the risk of a “future Northern Rock style run” on the pension system and the UK stock-market which could result in billions of pounds being withdrawn overnight.

“It would have to apply only to future contributions and would create a two-tier pension system, increasing costs and complexity for all involved. This scheme might save the Chancellor some money but only at the expense of the country’s long term retirement plans – it would involve a transfer of costs from today’s taxpayers to those of the future, and so would exacerbate intergenerational tensions.”