In April 2024, when the basic rate of income tax falls from 20% to 19%, there will be a corresponding reduction in tax relief on pension contributions. One newspaper labelled this a “stealth tax” – even though a £1 pension contribution will still cost a basic rate taxpayer £1 of pre-tax income and, to the extent that taxes on the associated withdrawal come down, more of that pound will be available to spend in retirement.
The point being made was that a basic rate taxpayer will have to forgo 81p of net income to finance each £1 pension contribution, rather than the 80p it costs now. Or, if you view basic rate tax relief as a top-up to contributions from post-tax income, this is being cut from 25% to a little under 23.5%. (When automatic enrolment was introduced, a Department for Work and Pensions language guide encouraged pension providers to tell new savers that the Government would add £10 for each £40 they paid in; that now becomes a less snappy “£10 for every £42.63”.)
Although beguilingly simple, this presentation never told the whole truth about fiscal rewards for saving through a pension. Even in the most straightforward case – where a contribution comes from an individual rather than an employer, so there is no National Insurance relief, and where there are no relevant interactions with the benefits system – it is necessary to take account of tax due on the way out.
The upfront ‘top-up’ can be the sole difference between contributing to a pension and saving in an ISA out of taxed income, but only where the retirement income a contribution generates then falls within the recipient’s personal allowance. Currently, the annual value of a full New State Pension leaves over £2,900 of the personal allowance unused. However, Office for Budget Responsibility forecasts point to this gap shrinking by more than half over the next five years, as the personal allowance is first frozen and then increased with inflation while the State Pension grows in line with the ‘Triple Lock’; this will reduce the scope for income saved through a pension to escape the taxman’s clutches both when it is earned and when it is received. By 2027-28, some retirees would, on these assumptions, be paying £287 in tax on income that would have been tax-free if the gap between the New State Pension and personal allowance had been held steady.
Beyond that first tranche of private pension income, only 25% can be withdrawn tax-free. With tax at 20p in the pound, a basic rate taxpayer who turned £800 of net income into a £1,000 pension contribution would be left with £850 after paying 20% tax on three-quarters of the withdrawal, a boost of 6.25%. With a 19% tax rate, the £1,000 pension contribution leaves the saver with £857.50, which is 5.86% more than its £810 cost. So a modest end-to-end incentive has been replaced by one that is slightly smaller.
In other circumstances, the move to a 19% basic rate improves the rewards for pension saving. This will be the case where pension contributions qualify for higher or additional rate tax relief (which on current policy will remain at 40% and 45% respectively) but the associated retirement income is taxed at the basic rate. The change also provides a retrospective boost to the reward for some of the pension saving that people have already done – adapting the example above, 20% tax relief on the contribution and 19% tax on three-quarters of the withdrawal turns £800 into £857.50.
All of this highlights how the tax advantage of saving through a pension depends on numerous ‘known unknowns’, including, but not limited to: income tax rates and thresholds in the future; whether the tax-free 25% survives; the level of the State Pension and the eligibility conditions prevailing in future; the pace at which withdrawals from a pension pot are made; and what other income the individual has in the same tax year. The exact size of this advantage cannot be known with precision at the time the contribution is made (except where the withdrawal is immediate). That may be maddening from a communications perspective, but most people can still expect that it will pay to save through a pension. In some circumstances, this is especially likely; we will explore some of these in future blogs.
