The taxation of pension savings is little understood but proposed reforms could have significant consequences
George Osborne’s announcement of a review to the system of tax relief on pension savings in this month’s budget might not have hit the headlines, but the consequences of reform could be very significant for all those currently saving for a pension.
The UK’s current system of tax relief on pension savings is based on the principle of deferred taxation. Employees and their employers pay into a pension scheme on a tax free basis, no tax is imposed on investment gains from pension savings, but tax is paid when income is drawn in retirement.
Costs of this tax relief have increased over the past decade as wages have risen and employers have increased their contributions to pension schemes, many to close deficits in remaining final salary schemes. The cost of income tax and national insurance relief on pension savings is now nearly £50 billion a year. Two thirds of the benefit from this relief goes to those paying the higher 40% rate of income tax and the 45% additional rate.
The principle that tax relief is a deferral of tax is undermined by the fact that many of those paying the higher rate or the additional rate of tax will pay tax at a lower rate once they retire. The current system can then be seen as being particularly generous to higher earners, despite changes since 2010 to limit the amounts on which tax relief can be claimed.
It has always been likely that the reforms allowing freedom to spend pension pots introduced in April would not be the end of the reform process, and the system of tax relief was likely to be looked at. What remains to be seen is how radical change could be.
The consultation document leaves the Treasury’s options open by stating that the result of the consultation might be that the current system ought to be left alone, or just slightly tweaked.
Recent signals currently coming out of the Treasury have, however, made it clear that they see the current cost of tax relief as a tempting target. One unnamed minister was quoted as advising higher rate taxpayers to “grab a bargain at the closing down sale while they can.”
Suggestions of possible reforms include switching the current model of tax relief around so there is no tax relief on savings, but income is drawn tax free in retirement. This would be an attractive solution for a Chancellor trying to reduce a huge budget deficit, as taxation can be taken now at the cost of reduced income tax receipts in years to come when savers retire, but turning the current system of tax relief on its head might prove to be too complex. Osborne’s own pensions minister, Ros Altman, has highlighted some of the problems that such a scheme could create.
The consultation makes it clear the Treasury wants to see a system that incentivises saving. Incentivising those on moderate incomes might be regarded as a more of a public policy priority as it is this group who tend to have the biggest savings gap and are more likely to fall back on state support if they are unable to save enough for their retirement. Steve Webb, the former Lib Dem pensions Minister, has long advocated a flat rate of tax relief on pension savings of 30% which would ensure that basic rate taxpayers would benefit the most from the system.
One possible outcome could be a radical rethinking of what pension savings are for. DWP Ministers and Number 10 have hinted at radical changes to the welfare system, meaning that those in work are incentivised to insure themselves against sickness or unemployment. An option could be the development of pension savings as a fund, which as well as providing for retirement, they can be drawn upon in the event of other needs such as sickness or unemployment throughout your life, similar to the US system of 401K plans. The Chancellor has called on Ministers to rethink the role of the state as part of his plan to deliver £20 billion pounds in savings by 2019-20, and the rethinking of the retirement and welfare system could be part of this.
While many beneficiaries of the current system of tax relief don’t fully understand how the system works, reforming a system which currently benefits middle class professionals is risky for a Conservative Chancellor and the political as well as the economic impact of any changes will be carefully considered before a decision is made.