Rumours have resurfaced that pension tax relief may be about to change. The former Chancellor Sajid Javid was said to be looking at a flat rate for all – but what would this mean for pension savers, and how likely is it? Article by Nick Green.
Some ideas just won’t die. Flat-rate pension tax relief looks set to have more comebacks than Tiger Woods. There were whispers that before his resignation, Chancellor Sajid Javid was looking at reforming the UK’s system of pension tax relief, a plan favoured by George Osborne back in 2016 before the then-Chancellor ditched it. If it happens under the next Chancellor – and it is a huge if – it would be one of the most radical Budget announcements ever made by a Conservative government.
Such a change would have the potential to rake in much-needed billions for the Treasury to offset the costs and challenges of Brexit. But it would prove hugely divisive for traditional Tory supporters, many of whom would end up paying for the policy directly.
What is pension tax relief?
When you pay money into a pension, the amount is immediately boosted by tax relief. For instance, if you are a basic-rate taxpayer and pay £80 into your pension, the government adds £20 to make it up to £100. This is because your gross income was originally taxed at 20 per cent. Money paid into a pension is free of tax, so that 20 per cent is paid back on each contribution. Therefore all your pension contributions are effectively increased by 25 per cent [sic] automatically (because every £80 turns into £100).
Higher-rate taxpayers (who pay 40 per cent tax) can currently claim back an additional 20 per cent via their self-assessment, while top-rate taxpayers can claim an additional 25 per cent. It is this extra tax relief that may be up for review, either in the upcoming Budget or at some later date.
How might pension tax relief be changed?
When the change was first mooted in 2015, it was suggested that tax relief might move to a single flat rate for basic, higher and top rate taxpayers. One recommendation – likely to have proven very popular – was that it should be set at 33 per cent. Besides being more generous to basic rate taxpayers, this would have been easy to promote as ‘pay in two pounds, get one free’. Higher-rate taxpayers would still have taken a small hit, but most would have found it acceptable.
However, the government's main motivation now is saving money, so such generosity today is unlikely. Speculation is rife that the rate of pension tax relief may drop to 20 per cent for everyone. This would go some way towards reducing the government’s spending on this relief, which is currently around £35 billion a year. But the cost of this measure would fall exclusively upon high earners, while offering no particular incentive for lower earners to support it either (since some of those will be higher earners one day).
In summary, such a move would be generally unpopular. This is presumably why George Osborne abandoned his plans, fearing loss of support before the EU referendum. But with the Tories now commanding a large majority, and Brexit officially irreversible, the government may conclude that they will never get a better chance to push this through.
The challenges of flat-rate pension tax relief
It isn’t just the unpopularity of this policy that Javid would have to worry about. Pensions in general are the proverbial can of worms, and a change in just one area can have ramifications elsewhere.
For example, switching to a flat rate of 20 per cent tax relief might force the abolition of salary sacrifice schemes. Currently, employees can reduce their National Insurance contributions by arranging to take a smaller salary, in exchange for higher employer contributions to their pension. This is a great incentive for people to save for retirement. However, if the UK had 20 per cent flat-rate tax relief, higher earners would be able to ‘game’ the system, using salary sacrifice to lower their salaries to below the higher-rate tax threshold. By this method they could save similar amounts of tax, and the Treasury would fail to increase its tax takings. Therefore it seems likely that such a change would spell the end of salary sacrifice.
Another potential hazard comes from defined benefit / final salary pension schemes. These work in a different way from most private sector pensions, which are defined contribution. Applying flat-rate tax relief to DB schemes would therefore be complex and would place a greater burden on employers – but failing to do so would lead to accusations of unfairness from those in DC schemes.
Is pension tax relief likely to change?
Steven Cameron, pensions director at Aegon, warns that reducing or abolishing higher-rate tax relief will deter some higher earners from pension saving. He said, ‘If [the rate is] set below 30 per cent, higher rate tax payers expecting to pay higher rate tax in retirement might find pension saving unattractive, undermining the success of automatic enrolment.’ He added, ‘When the Government considered such changes back in 2015, it found there are many complexities to consider, and unless these are thought through and solved, changes could do more harm than good.’
Gary Smith, a Chartered Financial Planner at Tilney, again raised the issue of disparity between DC and DB pensions – which remain widespread in the public sector. He said, ‘If the Chancellor doesn’t alter public sector schemes, this potential reduction in pension tax relief might only apply to private sector workers, which would be grossly unfair.’
Given how much work and complexity would be involved in such a change, it seems unlikely that this government will have workable plans ready to role in time for the 2020 Budget on 11 March. Nevertheless the writing may be on the wall for higher-rate tax relief, so those in a position to benefit from it should use it while they still can, by maximising pension contributions.