A raid on popular pension tax breaks to drum up money for other government priorities is reportedly on the cards in the upcoming Budget.
Pensions tax relief could be set at 20 per cent for everyone, potentially saving £10billion in payments to higher rate taxpayers.
This would tear up the long-standing principle of saving into a pension from untaxed income.
Pension top-ups: A £10bn raid would hit the wealthy and young, and offer no sweetener to lower earners
A ‘mansion tax’ on the owners of the country’s most expensive homes is also thought to be on the table on 11 March as Chancellor Sajid Javid considers how to raise money to fund plans to ‘level up’ the economy
In the wake of the Tories’ decisive election win, Javid could dust off a scheme to radically overhaul pension tax relief considered, but ultimately abandoned, by George Osborne ahead of the 2016 Brexit referendum, according to a report in the Financial Times.
The spectre of a raid on pensions tax relief, which at present allows everyone to save for retirement out of untaxed income, has haunted savers for years.
There has been speculation about big changes in the run-up to most Budgets since 2016, but it has always come to nothing.
So how would a move to 20 per cent rate pension tax relief across the board affect the country’s millions of pension savers, if the Government decides to go for it this time?
How would a 20% flat rate work?
Setting pension tax relief at 20 per cent for everyone would be far less generous than previous suggestions of a higher rate somewhere between 25 and 33 per cent.
At those levels, lower earners would get a bigger boost to their pension pots and higher earners would receive less than they do now.
Those on 40 or 45 per cent get the bulk of pension tax relief at present, although this is because they earn more and pay more tax.
However, it’s worth noting that people on the basic rate effectively pay 32 per cent to the taxman when 12 per cent National Insurance – which is levied before pension contributions are made and tax relief calculated on them – is taken into account.
Higher and additional rate taxpayers pay 12 per cent NI on their first £50,000 of income, and then 2 per cent on the rest – so 42 per cent or 47 per cent respectively.
Flat rate tax relief normally gets touted as taking money off the older and wealthier.
But the real losers from pension tax relief being cut back would be younger people whose pay could end up rising above the higher rate threshold in their working life.
The older, richer generation have already had a lifetime of higher relief, and benefited from more generous and guaranteed final salary pensions as well.
‘Younger workers are more likely to be basic-rate taxpayers, with most enjoying their highest wages in the later stages of their careers,’ says Tom Selby, senior analyst at AJ Bell.
‘If tax relief were to be limited at 20 per cent, young people – who have already missed out on cheap housing and generous defined benefit provision – would be unable to claim the extra tax relief bonus that was available to their parents.’
How likely is a 20% flat rate?
The Government has pondered moving to a ‘flat rate’ system where all savers get exactly the same rebate many times, but always backed off in the end.
Another option has been introducing a new ‘Pensions Isa’ where everyone saves out of taxed income and less money goes into pension pots as a result.
But people would have to save out of taxed income, and then trust the Government not to wallop them with tax again when they reach retirement.
Osborne is thought to ditched both ideas for fear of a backlash among voters before the EU referendum.
The current government is also likely to face fierce opposition, including from traditional Tory supporters, but is more likely to face this down given its comfortable majority.
The next election is a long way off and the move could free up billions of pounds for other projects.
However, pension experts routinely warn changes would create a financial hole in the retirement funds of many people, and there would be daunting practical problems to changing the current regime.
What are the practical obstacles?
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A 20 per cent flat rate could mark the end of salary sacrifice schemes, where staff and employers boost pension payments in order to cut their National Insurance payments.
‘This can offer tax benefits to some employees and employers and also has an added advantage in that employer but not employee contributions are exempt from National Insurance,’ says Steven Cameron, pensions director at Aegon.
‘In future, if the flat rate of tax relief was below an individual’s income tax rate, they would benefit from going down this path. The Chancellor would need to close this loophole or fail to cut the pensions tax relief ‘bill’.’
Income tax rates are higher in Scotland, at 21 per cent for basic and 46 per cent for higher rate taxpayers.
But Cameron believes the Government could get around this by effectively detaching pension tax relief from income tax rates, allowing it to apply the 20 per cent flat rate north of the border too.
A thornier issue would be that defined contribution and final salary pension schemes work in different ways, and it would be much harder to apply a 20 per cent flat rate to the latter.
‘In defined benefit schemes, while employee contributions are fixed, contributions from employers change over time to deliver promised benefits and are not ‘earmarked’ for individuals,’ explains Cameron.
‘Looking at the overall funding of such schemes, if tax relief across all employee contributions fell, the employer would be left having to pay more to compensate. Much detailed thinking is needed to decide how to make flat rate relief work for members and employers with defined benefit schemes.’
Cameron added that it would ‘hugely divisive’ to introduce a 20 per cent flat rate for defined contribution schemes, while leaving the system for defined benefit schemes unchanged and their members receiving preferential treatment.
One very contentious aspect of pension tax has been the so-called ‘taper problem’, which sees doctors turn down shifts for fear of shock bills.
A 20 per cent flat rate of pension tax relief would not solve this directly, but higher earners like doctors would put less money into pensions so fewer might encounter this problem, according to Cameron.
It is unclear how such a change would impact annual and lifetime allowances, which limit how much people can put in a pension and get tax relief over a year and during their working lives.
The annual allowance is currently £40,000 for most people, but reduced or ‘tapered’ to £10,000 for higher earners like doctors. The lifetime allowance is curently £1,055,000, and will rise to £1.073million in April.
However, the ‘net pay’ issue, a separate pension tax relief problem affecting low paid people, would be sorted out by the introduction of a 20 per cent flat rate.
This is a loophole which sees workers, mostly women, earning between £10,000 and £12,500 lose pension top-ups automatically paid to the better off, but this would be a moot point if everyone got the same level of pension tax relief.
What do pension experts say?
‘Moving to a flat rate somewhere between basic and higher income tax rates would be good news for non-taxpayers and basic rate taxpayers, while higher and additional rate taxpayers would see their government top-ups reduced,’ says Steven.
‘In terms of simple appeal, a flat rate relief of 33 per cent would see the Government add £1 for every £2 from individuals.
‘But if 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 which ‘works’ because pension saving is in virtually everyone’s interest.
‘Simply removing higher rate relief and granting 20 per cent relief to everyone would not affect basic rate pension savers but would severely dent the attractions for higher rate taxpayers many of whom are far from ‘wealthy’.
‘While there are benefits in flat rate relief, 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.’
Tom Selby adds: ‘Barely a Budget goes by that the Treasury isn’t rumoured to be eyeing radical pension tax relief reform.
‘This constant speculation risks altering investor behaviour and damaging confidence in the stability of the system.
‘Ironically, in the short-term such stories will inevitably cost the Exchequer cash as savers pile into pensions to make the most of tax relief while it is still there.
‘If there are to be reforms to the pension tax framework, they must not risk harming the fragile savings culture that is being developed in the UK.
‘We believe the focus at the moment should be improving the existing system rather than burning the whole edifice to the ground.’
Gary Smith, chartered financial planner at Tilney, says: ‘A potential of scrapping of higher rate tax relief on pensions has repeatedly reared its head since George Osborne commissioned a consultation into the future of pensions tax relief during his tenure as Chancellor.
‘A new Government with a commanding majority may well feel it is a position to implement such a policy that would prove unpopular with those impacted.
‘However, in contemplating such as move, the Government needs to give careful consideration as to how this might impact public sector professionals, especially doctors working in the NHS, where previous tinkering with pension taxation has caused chaos.
‘I would be interested to know how the removal of the higher rate pensions tax relief could be applied to public sector pension scheme members, as their pension contributions are currently deducted from gross salary before income tax is calculated, thus they automatically receive high rate relief.
‘If they were to alter this, it would increase the tax liability for NHS workers, which could actually make the current crisis even worse.
‘However, 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.
‘Removing the higher rate relief means that he would also have to scrap salary sacrifice arrangements as higher rate relief would effectively be obtained if this option remains.
‘There are also those business owners who actually make pension contributions through their business to obtain corporation tax relief, and these would be unaffected by scrapping higher rate relief.’
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