With pension tax relief under the spotlight, why now’s the time to act
Posted onOver recent months, there has been speculation that pension tax relief could be set for significant reforms. Former Chancellor, Sajid Javid, was keen on making changes, and while Rishi Sunak has been quiet on any potential reforms, changes could be accelerated by the requirement to raise additional funds as a result of the coronavirus response.
With pension tax relief costing the Treasury almost £40 billion a year, changes to the system could certainly be one way of the government raising revenue. So, what might change, and how could it affect you?
How the current system benefits taxpayers
When paying into a pension, you receive tax relief on any contributions you make. Under the current system, the amount of tax relief you receive on your pension contributions depends on the rate of Income Tax you pay. This means that higher and additional rate taxpayers get a bigger top-up than basic rate taxpayers.
This system costs the Treasury around £38 billion a year in lost Income Tax revenue. And, a report by the Pensions Policy Institute revealed that half the value of the available pensions tax relief is claimed by the 15% with the highest incomes (over £60,000).
In February, it was reported that former Chancellor Sajid Javid was looking to make the system fairer for those on lower incomes. And, with a black hole in the public finances to pay, this speculation has recently resurfaced.
The most likely course of action is that the government will reduce higher and additional rate tax relief on pension contributions and replace these with a flat rate of relief, regardless of how much you earn. This could be at the same level as basic rate tax (20%) or introduced at a slightly higher level – perhaps at 30% or 33%.
The other option under consideration is that tax relief on contributions is scrapped altogether, and that tax relief is given at the point you draw your pension (similar to an ISA-style arrangement).
The pros and cons of introducing a flat rate of pension tax relief
Proponents of reform argue that introducing a flat rate of relief will help to close the gender pensions gap and be fairer for those on lower incomes.
A study by the Pensions Policy Institute found that, despite the fact that those earning less than £30,000 a year make 63% of all pension contributions, they are only receiving 24% of the total tax relief.
They also found that men receive the vast majority of pension savers’ tax perks, with 71% of all pension tax relief granted to them.
The institute also revealed how the tax system benefits older people. 42% of those who contribute to a Defined Contribution pension are under 40 but they receive only 27% of the available tax relief. People in their 40s and 50s typically receive two and a half times as much tax relief.
While there are some clear reasons for introducing a flat rate, Steve Butler, author of The Midlife Review: A Guide to Work, Wealth and Wellbeing, says that there are three main challenges for introducing such a reform:
- The taxation of pensions is treated differently for employees and employers. This means that any change to employee taxation needs to consider the changes to the way employer contributions are taxed.
- Many employers offer ‘salary sacrifice’ arrangements under which employees ask their employers to make pension contributions on their behalf, in return for taking a lower salary. A flat rate of relief would end this, otherwise, individuals using this arrangement would still benefit from full tax relief.
- How would this relief affect Defined Benefit (final salary) pension schemes? If the tax relief on employee contributions fell, would employers have to pay more into schemes to enable the same benefits?
Steve adds: “These challenges should not stop the debate around the introduction of a flat rate of pension tax relief but, they certainly need to be considered before any progress can be made about changes to pension taxation if it is to achieve what it set out to do.”
What you need to think about
With a review under way, it is possible that the Chancellor could make changes to pension tax relief as early as this autumn’s Budget – and these changes could come in with immediate effect.
If Rishi Sunak does decide to introduce a flat rate, it could affect you if you’re a higher or additional rate taxpayer. So, it could pay to maximise your pension contributions now, while 40% or 45% tax relief is still available.
For help with your pension planning, email enquiries@blackswanfp.co.uk or contact your adviser on 020 3828 8100.
Please note
A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation which are subject to change in the future.
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