What should happen to pension tax relief in the upcoming Budget?

Robert Salter examines some of the problems caused by the current system and how pensions tax relief could be reformed.

In the run-up to Wednesday’s Budget, it is clear that various parts of the tax system are “not working”, that is, they create negative behaviours on the part of those affected and potentially damage the wider economy, while undermining the sense people have of the tax system being broadly fair and reasonable, or just. 

One area where the weaknesses are most obvious is with regard to pensions tax relief. 

As things stand, most taxpayers with a money purchase or defined contribution pension scheme can put up to £40,000 a tax year into the pension plan on a tax-efficient basis – that is, no tax liability arises with regard to employer contributions and employee contributions qualify for income tax relief, up to this limit.  

Clearly, most people will not be able to put £40,000 a year into a pension scheme. However, for higher earners (which, in simple terms is someone with annual income from all sources over £150,000 on an “adjusted income basis”, so pension contributions are regarded as income for this purpose), the annual limit for tax-efficient contributions is reduced on a straight-line basis to potentially only £10,000 a year. 

The taper reduces the total allowable pension contributions on a £2 for £1 basis – i.e. for every £2 you have of adjusted income between £150,000 and £210,000, the tax-efficient pension contributions limit reduces by £1. Contributions in excess of the relevant limit are taxed as additional income at a rate of 45%. 

Simple examples of the problems that are being caused by the present arrangements include:

• Consultants in the NHS refusing to work additional shifts to avoid becoming liable to the tax liability on pension contributions;
• People reducing their pension contributions (and, for example, taking additional cash payments from their employer), at a time when the UK has an ageing population and needs people to save more for their retirement.

The above problem is compounded by the fact that pension contributions are also liable to a lifetime allowance (presently £1.055 million). Pension funds in excess of this lifetime limit will be subject to an effective tax liability of 55% when withdrawn. While most people will not exceed this lifetime limit, many GPs, for example, are retiring early because the rules mean that they could become liable to a 55% charge on part of their pension.

As such, the government needs to remove these rules and allow all employees/self-employed individuals to make the same absolute maximum level of contributions each year. I would suggest retaining the existing £40,000 annual maximum contributions limit in this regard, and removing the lifetime allowance limit. 

The above arrangements would increase the costs of pensions tax relief for the government. As such, some changes might be required to try and manage the overall budget. Options in this regard could include: 

• Restricting the absolute value of an individual’s pension tax relief. At the moment, tax relief is given at their marginal tax rate – so 40% or 45% for higher-rate taxpayers. Instead, relief could be restricted to some lower amount – perhaps 25% or 30%.
• Alternatively, national insurance could be imposed on employer pension contributions, for example, either at the 13.8% regular rate of employer NIC, or perhaps some special lower rate. 

Both these options would help restrict the absolute cost of removing the pension taper relief restrictions and could arguably be justified on the grounds of fairness. For instance, from an income tax perspective, higher-earning executives and professionals would be getting tax relief for pension contributions on a basis that is broadly akin to the wider population, where people with income of £50,000 or less presently get tax relief only at 20%. 

While making pensions tax relief fit-for-purpose will require some careful balancing on the part of the government, the reality is that if the government wants people to save sufficiently for their retirement and ensure that the system is working effectively and fairly for the majority of the population, retaining the status quo is not a realistic option.

Robert Salter is a senior adviser at Blick Rothenberg.