Pension tax relief – why now is the time to take action quickly

As well as the devastating human cost of coronavirus, the pandemic has wreaked havoc with the UK economy. The deficit is now expected to be £394 billion in 2020/21; this figure is an eye-watering £339 billion higher than had been anticipated before public health restrictions were first imposed back in March 2020.

Last year, we looked back at the aftermath of the second world war and what history can teach us about where taxes might go next. One thing is clear: the chancellor has an enormous hole in the public purse and so it’s highly likely that tax rises are coming.

Over the past few months, there has been one particular rumour that won’t go away. Speculation has been rife that the government will finally reform pension tax relief – a tax break that costs the Treasury around £35 billion every year.

If you’re a higher or additional-rate taxpayer, this is likely to be bad news. Here’s what might change and what you should consider ahead of any reforms.

A quick refresher on the benefits of pension tax relief

When you make a pension contribution, the amount you pay in is immediately boosted by the tax relief you receive.

If you are a basic-rate taxpayer and pay £800 into your pension, the government adds £200 to make it up to £1,000. As your gross income was originally taxed at 20%, and money paid into a pension is free of tax, that 20% is paid back on each contribution.

If you’re a higher-rate taxpayer (40% tax) you can currently claim back an additional 20% through your self-assessment. This means that your £1,000 pension contribution only costs you £600. Additional-rate taxpayers can claim an additional 25%, so your £1,000 contribution only costs you £550.

It is this extra tax relief that the chancellor has his eye on and could reform in the upcoming Budget.

Changing to a flat rate of tax relief

The idea of changing to a flat rate of tax relief is not a new one; indeed, it was first considered back in 2015. One recommendation at the time – likely to have been popular – was that there should be a flat rate of tax relief at 33%.

This would have helped to encourage pension saving among basic-rate taxpayers as for every £2 contributed, they would have received £1 in the form of tax relief. Even though higher and additional-rate taxpayers would have seen their tax relief fall, many would have still found it acceptable.

Now, however, it’s much more likely that the chancellor will either introduce a flat rate at around 25% or remove higher and additional-rate relief altogether, meaning tax relief would just be paid at 20%.

A flat rate of pension tax relief would impact higher earners

Any move to a flat rate of relief that is lower than 40% or 45% would impact on higher earners.

Here’s an example using a flat rate of 25%:

• A basic-rate taxpayer paying £100 a month into their defined contribution pension would see this topped up to £133.33, rather than the current £125.
• A higher-rate taxpayer who currently sees their £100 increased to £166.66 would see this reduced to £133.33.

Aegon pensions director, Steven Cameron, says: “It would be good news for basic-rate taxpayers who’d receive a more generous bonus but would create a big dent in the future pension pots of higher and additional rate taxpayers unless they increased their contributions.”

So, what can you do to mitigate any possible change?

The first thing to consider is maximising your pension contributions while you can at the current rate of tax relief. At present, your Annual Allowance means you can pay in up to £40,000, or 100%, of your earnings and benefit from tax relief.

In addition, “carry forward” allows you to make use of any Annual Allowance that you may not have used during the three previous tax years.

It would make sense to maximise your pension contributions and benefit from 40% or 45% tax relief now, as any changes could come into force in the 2021/22 tax year.

But what about final salary (defined benefit) schemes?

Any reform to defined contribution pensions would be relatively easy to implement, as it would simply be the rates of tax relief that would change.

However, final salary schemes operate the “net pay” system, which automatically gives tax relief at your highest marginal rate of tax. These would be much more problematic to change. Options might include:

• The removal of “salary sacrifice”. Many employees choose to reduce their National Insurance contributions by arranging to take a smaller salary in exchange for higher employer contributions to their pension. So, under a flat rate system, higher earners could simply use salary sacrifice to lower their salaries to below the higher-rate tax threshold. Salary sacrifice might therefore have to be scrapped, so consider using this benefit now.
• Moving to a “relief at source” basis. A reduction in tax relief on contributions, without simultaneously altering the benefits provided by a final salary pension, means that an employer would have to make a higher payment. This would result in increased costs to business; bear in mind that the government is effectively the employer for many final salary scheme members!
• Apply a tax charge to reclaim an excess tax relief given. This could lead to unexpected tax bills and a repeat of the issues faced by many under the controversial Tapered Annual Allowance.

Steven Cameron from Aegon adds: “For consistency with those contributing to defined contribution schemes, higher and additional-rate taxpayers in defined benefit schemes might see their and their employer’s contributions taxed as a benefit in kind, increasing their tax bills.”

Get in touch

With potential reform on the way, now is the time to maximise your pension contributions to benefit from the tax relief currently available. Pensions can be a complex area, so get in touch to speak to one of our specialists. Email enquiries@blackswanfp.co.uk or contact your adviser on 020 3828 8100.

Please note

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Your pension income could also be affected by the interest rates at the time you take your benefits. Levels, bases of and reliefs from taxation may be subject to change and their value depends on the individual circumstances of the investor.