The Chancellor has signalled that the 30 October Budget will include tax rises and there has been speculation that this might include changes to how income saved through a pension is taxed.
A “flat rate” of tax relief on pension contributions (not favoured, according to recent, seemingly authoritative, reports) and cuts to tax-free lump sums are the changes that have been talked about most, but there are a variety of ways in which revenue could be raised. Other potential options include: reducing National Insurance relief on employer pension contributions; changing how pension assets are taxed on death; reinstating the Lifetime Allowance (LTA) or reducing the Annual Allowance (AA); or even turning the tax treatment of pensions upside down so that taxes are applied up front rather than in retirement.
As with most things, changes are easier said than done. For example:
- Flat rate relief: Most pension contributions are paid by employers, so would be out of scope if a flat rate of relief applied only to individuals’ contributions. To bring them into scope, employees would have to be taxed on the value of employer contributions.
- Where this took someone’s income over the higher rate tax threshold, basic rate taxpayers could lose out from restricting higher rate relief.
- It is not possible to assign employer contributions to individual members of defined benefit (DB) schemes in a way that is both fair and straightforward.
- Even in defined contribution (DC) schemes, the implementation methodology would determine whether amounts reaching pension pots or take-home pay changed.
- Restricting tax-free cash: Cutting the maximum amount of tax-free cash that savers can take (normally this is currently 25%, up to £268,275) would either: move the goalposts for people approaching retirement; or be phased in slowly, with little revenue raised for some time. Even if most savers were unaffected, many might fear further cuts and withdraw money hurriedly.
- Taxing pensions like ISAs with a Government top-up: Existing pension savings (taxable in retirement) would have to be segregated from new savings (tax-free in retirement) or converted via a one-off levy.
- Lifetime Allowance restoration: Labour kept this policy out of their manifesto for good reasons – including that it would have invited questions about the effect on public services and about the fiendishly complicated process of restoring it (even abolishing the LTA has proved difficult enough).
It’s partly for these reasons that changes which have been talked about for years are not already in force: if the fruit were as low-hanging as some believe, it would already have been picked.
The articles within this series explain the background to the current debate and explore the more frequently cited policy options.
Taxing questions
A Government interested in raising revenue by changing the taxation of pensions would have to consider the following high-level questions before formulating detailed proposals:
- What is its most important goal? Is it simply to increase tax revenue (decrease tax relief)? Or does it have a redistributive element? Are there simpler – and therefore quicker – ways of achieving that goal?
- When does the Government want to tax pension savings and accrual?
- At the point of saving?
- After each tax-year of saving?
- When benefits are first accessed (“crystallised”)?
- As and when benefit instalments are paid?
- Who will the losers be?
- Employees but would that be in the form of
- Increased tax bills e.g. reduced take-home pay or
- Reduced pensions?
- Employers? Even if politically feasible, it would make it relatively less attractive for employers to pay pension contributions.
- Savers who have already done most of their pension saving: Changing the tax that applies to pension withdrawals, such as by limiting future tax-free lump sums, would be seen as “moving the goalposts”.
- How would a new approach to taxing pension savings and accrual work for the employee and employer contributions, and in each kind of pension provision? How would it be administered? One of the articles in this series considers ways of applying a flat rate of relief to standard DC or DB pension designs. But the Government would also need to apply relief to “hybrid” (or “better of”) benefits, schemes where the defined benefit is a pot value rather than an annual income, and to new collective defined contribution schemes.
The context: this is not year zero
The above questions would be challenging enough if introducing a system with no history of pension provision (and no transition) to consider. However, the UK pension landscape contains further obstacles to navigate given it has been in place and evolved oved over a long period of time:
- The current UK system taxes pensions when they are paid and not when the rights are building up. In this context, “relief” on contributions primarily changes when the tax falls due on income that is saved; it is deferral rather than an outright exemption.
- Crucially, this includes not taxing employees upfront on the value of pension contributions paid by their employers. If changes to tax relief were confined to individuals’ contributions, employees could escape higher taxes by exchanging salary for employer pension contributions.
- Applying flat rate relief to defined benefit pensions would confront some members of public sector schemes with large tax charges that they do not face today. The Government is halfway through a 25-year commitment that limits its ability to further reform public service pension scheme provision, and the recent abolition of the Lifetime Allowance (LTA) and increase in the Annual Allowance were intended to improve work incentives for higher-paid public sector workers. On the other hand, it might be politically challenging to take 40% relief away from almost all higher rate taxpayers in the private sector while keeping it for those in the public sector (including MPs).
- Other countries with similar systems may limit tax relief on pension contributions and accrual; however, like the UK, this is usually by setting a limit or an additional tax charge on “excess saving” but otherwise maintaining full marginal relief upfront.
- It is important that any structural changes are not rushed through. Abolition of the LTA provides all the evidence needed of why this doesn’t work well. However, giving advance notice of a tightening of the tax regime could lead to “buy now while stocks last” behaviour and, to protect against this, immediately effective anti-forestalling measures might be considered necessary.
- Treating all pension contributions/accrual as part of an employee’s taxable income would have wider consequences. As well as pushing many employees into higher tax bands, the higher “incomes” could cause some members to lose out in other ways – e.g., Child Benefit various subsidised childcare schemes, and income tax personal allowance withdrawal. Some existing ”cliff edges” and high marginal deduction rates could be shifted down the income scale.
- Unlike tax relief on contributions, the tax-free lump sum is a genuine end-to-end reward for pension saving. Were HM Treasury designing a pensions tax system from scratch, it would probably not allow amounts up to £268,275 to escape tax altogether. However, reducing the maximum (say to £100,000) would raise very little revenue in the short/medium term if existing lump sum “entitlements” were to be protected. And if they were not protected, that could be seen as moving the goalposts and threatening further reductions - removing what is, to many people, the most appreciated feature of pension savings and a strong incentive to participate in pension schemes.
- The other end-to-end fiscal reward for pension saving is the exemption from National Insurance contributions on employer pension contributions. If the employer NI exemption were removed, the cost of employing people would increase, with these costs either making it harder to do business or being passed on to employees. Even if a rate lower than the full charge were applied, there may be concerns it might be ramped up in future. There are also good reasons for targeting incentives (such as the NI exemption) on employer contributions. Different combinations of tax and National Insurance changes could either increase or reduce (or even render redundant) the use of pension salary sacrifice to reshape pay packages.
- The income tax treatment on bequeathed pension assets can be generous, especially where the saver dies before age 75. If reviewing this, the Government would want to consider the intended tax treatment where someone dies much younger, perhaps with a family to support. Ultimately, any difference in income tax treatment between bequeathed pots would seem likely to have to be based either on the saver’s age at death or on whether they had started to access their savings.
- Bringing pension death benefits into the scope of Inheritance Tax could render the estate responsible for paying tax in relation to assets distributed by the scheme trustees to a third party and could materially slow down the process of getting the financial support to the bereaved dependants. Limiting the scope for schemes to pay death benefits, or raising the tax on those benefits, would likely be an easier way of raising tax on them than seeking to route the benefits through inheritance tax or overhauling existing trust law.
