There has been a great deal of speculation, particularly over the last 18 months, around potential increases to the tax landscape. Capital gains tax and Inheritance Tax have both been marked as ready for an overhaul. Discussions of a ‘wealth tax’ have also been on the table.
Another option to increase tax revenues would be to change the structure of pension tax relief. Pensions have changed significantly in the last 20 years, with Pensions Simplification (2006) and Pension Freedoms (2015) being the most notable milestones.
But any legislation will need to strike a careful balance between increasing tax inflows while still encouraging people to save for their retirement.
How Does Pension Tax Relief Work?
Currently, the following tax benefits apply to your pension:
- Personal contributions receive tax relief at source. This means that if you pay in £80, your pension receives an additional £20 from HMRC.
- Higher and additional rate taxpayers can claim further tax relief. This means that a gross contribution of £100 could cost as little as £60 or £55 depending on your tax bracket.
- If you make contributions through salary sacrifice, you could also receive relief on your National Insurance Contributions.
- Company contributions are an allowable expense for corporation tax purposes.
- When your pension fund is invested, no income tax or capital gains tax applies within the fund. This helps your pension to grow more quickly than other types of investment.
- From age 55, you can draw a tax-free lump sum of 25% from your pension. This can be taken all at once or in stages.
- Any further withdrawals are classed as income and are taxed at your marginal rate.
- On death before age 75, you can pass your pension on to your beneficiaries free of tax. After age 75, your beneficiaries can either take withdrawals (taxed at their own marginal rate) or preserve the fund for their own beneficiaries.
What Are the Limitations?
The tax relief on pensions is generous, but it is not unlimited. The following restrictions apply.
- Personal contributions are limited to the higher of £3,600 (gross) and your relevant UK earnings. This means if you earn £40,000, you can pay £32,000 into your pension and tax relief will top this up to £40,000.
- Personal and employer contributions are further limited by the annual allowance of £40,000. However, if you have been a member of a pension scheme, but have not fully used up your annual allowance, you can carry it forward by up to three tax years.
- Anyone earning over £240,000 has a tapered annual allowance. This is reduced by £1 for every £2 of earnings over the threshold. Those earning over £312,000 can contribute up to £4,000 per year.
- Anyone who has taken flexible benefits from their pension is subject to the Money Purchase Annual Allowance. This reduces the annual allowance to £4,000 and removes the option to carry allowances forward. The intention is to stop people from benefiting from double tax relief.
- The Lifetime Allowance is currently £1,073,100. Pension benefits above this level are taxed at 55% if taken as a lump sum, or 25% plus income tax if taken as income. Your pension will be tested against the Lifetime Allowance when you take benefits, reach age 75, or if you die before either of these events.
While higher earners can benefit the most from pension tax relief, they also face the highest penalties for overfunding. Advice is recommended, particularly if your situation is complex.
How Could Relief be Reduced?
At the moment, there are no concrete plans to reduce pension tax relief. If this does go ahead, any of the following would be possible:
- Limit tax relief on contributions to the basic rate.
- Reduce the annual allowance.
- Remove the option to carry forward contributions.
- Reduce the level of earnings at which the tapered annual allowance applies. This would be controversial, as the threshold has only recently increased to £240,000 from £150,000.
- Make it more difficult for company directors to make large pension contributions through the business.
- Remove the tax-free cash entitlement. Rumours of this possibility have circulated since 2006 when the official terminology was changed to ‘pension commencement lump sum.’
- Reduce the Lifetime Allowance. Again, this would be difficult to sell as it has already been reduced several times since it was introduced.
It’s important that any new measures do not discourage the average working person from contributing to their pension. The majority of people will be reliant on their pension to provide a retirement income and will not have other wealth to fall back on.
The likelihood is that any measures that do come into play will target higher earners or those with already large pension pots.
Taxing pensions more heavily may not directly increase tax revenues, as many people will simply opt to reduce their contributions. However, it could lead to more money circulating in the economy.
Other Options to Reduce Tax
Of course, if pension tax relief is reduced, there are a few other ways in which you can keep your tax bill under control. For example:
- Contribute to your ISA. While there is no tax relief on contributions, income, growth, and withdrawals are all free of tax.
- Invest any lump sums in a bond. No personal tax applies when the bond is invested, and you can withdraw up to 5% of your premium per year without tax liability. You only pay tax if a chargeable gain occurs, for example if you exceed the 5% allowances or you encash the bond in full. Offshore bonds have the added advantage of no tax being deducted within the funds.
- Consider investing in smaller or less established companies via Alternative Investment Markets (AIM), Venture Capital Trusts (VCTs) or Enterprise Investment Schemes (EIS’). These provide tax advantages, but can also be very high risk.
Should You Still Contribute to a Pension?
Any reductions are likely to take the form of tweaks to the existing rules rather than a sweeping overhaul. It would be foolish to introduce legislation that discourages the population en masse to contribute to their pensions, as that means storing up a crisis for the future. The main target of any new rules will probably be the people (or organisations) who can afford to take good tax advice and reduce their liability through other means.
It’s important to note that any reductions to pension tax relief are purely speculative at this point. You shouldn’t reduce your pension contributions, and in fact, most people could benefit from increasing them further.
Please do not hesitate to contact a member of the team to find out more about your investment and retirement options.