Two pounds in your pension, get one free?

Pensions Minister Steve Webb has proposed a new flat-rate of tax relief on all pensions. It might be unwelcome news for higher and top rate taxpayers – but would be very exciting for everyone else. Here’s why.

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You pay in £2. The government adds £1. It sounds both good and simple. And it could become the next big change in a string of sweeping pension reforms.

No-one knows yet if it will actually happen, or how soon, but it could make a positively seismic difference to many people’s retirement savings.

Simpler and fairer?

The current system of tax relief on pensions has always been seen as quite simple. Whatever you pay into your pension is free of tax. This means that if you are a basic rate taxpayer (paying 20 per cent income tax) and you contribute £80 into your pension, you actually increase the fund by £100. This is because £100 taxed at 20 per cent would be £80, so the government ‘gives back’ the £20 worth of tax when the money goes into your pension.

What this also means, of course, is that the higher the rate of tax you pay, the more tax relief you get on pension contributions. Higher-rate taxpayers enjoy 40 per cent relief, while top-rate taxpayers have 45 per cent – so they would only need to pay £60 and £55 respectively to achieve that same £100 contribution to their fund.

When you think about that too hard, it may start to make less sense. Under the current system, wealthier people have far more incentive to save into pensions than those on average incomes – so the people who need pensions the most have the least encouragement to make use of them. That, at any rate, is the conclusion of Steve Webb MP, the Liberal Democrat Pensions Minister.

Mr Webb has said he wants to introduce a flat-rate tax relief of 33 per cent for all pension savers, regardless of income tax band. This would make a huge difference to the vast majority of people, who would see their basic rate tax relief increase significantly (to get that £100 would now require a contribution of just over £66 pounds… we won’t fuss around with decimal points here). Mr Webb has argued that this would not only be fairer, but also simpler for everyone to understand.  He explained, ‘You would be able to say to the public … that for every £2 you put in a pension, the government will put in £1.’ Tax relief can be a hard thing to get your head around, but everyone understands ‘Buy Two, Get One Free’.

You can’t please everyone…

Not everybody would be better off, of course – higher and top-rate taxpayers are unlikely to welcome this proposal. To offer them some consolation, Mr Webb has proposed scrapping the £1.25 million lifetime limit on pension saving which currently restricts such top-earners (it would also remove a layer of administration, making things simpler still).

It’s worth emphasising here that this is a Liberal Democrat proposal, so whether it happens at all may depend on the outcome of the General Election. Still, there’s nothing to stop another party from pinching or adapting the idea.

Lately there have been so many changes and proposed changes to pensions that anyone could be forgiven for not keeping up. Whenever you make decisions regarding your pension, make sure you talk to your financial adviser to be clear about what’s changed, what might change in the future, and what you ought to do about it. If you don’t yet have a financial adviser, find yours here.

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