15th July 2013
A new report from the Pensions Policy Institute is arguing for a shake-up of pension tax relief so that it better benefits low and middle income savers writes John Lappin.
The report says the main beneficiaries of the current system are higher rate taxpayers and argues there may be better ways to incentivise saving.
That is not too surprising a conclusion on first reading. Higher rate tax payers do after all get higher levels of relief, though these have been getting less generous with restrictions on the amount an individual can save in a year and in a lifetime imposed in the last few years.
Among other things, the report says the Government might consider flattening the tax relief to 30 per cent for all people which would no doubt prove a popular move with those who get a lower rate of relief at the moment. In effect, their pension contributions would stretch further.
Right now, savers can take up to 25 per cent of their pension pot at retirement age, but the PPI has said that this tax-free lump sum could be restricted to 20 per cent or to around £36,000.
But as with any such suggestions, it is the weight given to it by the Government that really matters.
Therefore savers may want to keep their eye on the fact the Treasury has welcomed the report and said that there needs to be a public debate about the rising cost of pensions tax relief, as trade website Money Marketing reported this morning.
It may be wise, if you can afford to, to make maximum use of your reliefs while you still can. Whether the PPI’s recommendations are actually taken up or not, the direction of travel is clear.
For those interested in the arguments, here is the Pensions Policy Institute’s case.
Director Chris Curry says: “Pension tax relief offers important tax advantages, particularly to higher rate taxpayers. However, despite tax relief on contributions costing up to £35bn a year after allowing for the introduction of automatic enrolment, tax relief is poorly understood and there is little evidence that it encourages pension saving among low and medium earners.
“The current system of pension tax relief favours higher and additional rate taxpayers. Even with pension saving boosted for lower earners by automatic enrolment, basic rate taxpayers are estimated to make 50 per cent of pension contributions, but receive only 30 per cent of pension tax relief on contributions.
“Pension tax relief on lump sums, at an estimated cost of £4bn a year, is similarly uneven. While only 2 per cent of lump sums are worth £150,000 or more, they attract almost one-third of tax relief on lump sums.”
And the PPI itself does say there is complexity.
“Implementation of a single rate of tax relief would be far from straightforward, with significant changes in the administration of pension contributions required. The resulting tax charges could be very difficult to understand and lead to changes in behaviour by employees and employers.”
There are opposing views from the pensions and investing industry and it is no surprise that Hargreaves Landown has put those together. Head of pension research Tom McPhail points out that capping the lump sum may sound reasonable but that it would be hitting people with relatively small pensions and that the suggested changes may not be as fair as they first seem. We have included some of his criticisms below under the headings he has provided.
Capping the lump sum
“The PPI report looks at the possibility of capping the tax free lump sum at £36,000. This may sound a lot, three-quarters of lump sum payouts are for less than this amount. However, a tax free lump sum of £36,000 would mean an investor being left with a fund of £108,000 with which to secure a retirement income. For someone aged 65 today, this would deliver a secure inflation-linked income of just £3,571. This is not fat-cat territory, in fact this is a relatively modest level of income even for someone retiring on average earnings.”
“Any change to the tax relief system which breaks the link between income tax rates and pension tax relief rates is going to make life complicated. We saw this very clearly in 2009 when the previous government created hugely complicated rules to try and prevent higher earners from enjoying full marginal rate tax relief. In the end the rules were scrapped before they were even introduced, because they made such a mess of the system”.
“Having seen constant tinkering with annual and lifetime allowances, with the tax reliefs and the income withdrawal rules at retirement, investors are already nervous about any further changes to the system. Any suggestion that the government might withdraw tax breaks, just as we embark on auto-enrolment could have a catastrophic impact on people’s willingness to save for retirement”.
“The principle of the current system is to avoid double taxation. In fact the current system is imprecise, with non-taxpayers receiving basic rate relief, higher rate taxpayers very often becoming basic rate taxpayers in retirement and everyone receiving 25% of their fund tax free. Nevertheless, any move to restrict tax relief for higher earners would be perceived as unfair. It is important to bear in mind that the top 10% of taxpayers pay over half of all tax revenues to the exchequer. Under the PPI’s modelling, even if we moved to a single rate of tax relief, higher earners would still receive proportionately more tax relief than basic rate tax payers for the simple reason that they have more disposable income.
“What’s more, the higher rate threshold is now effectively just £41,450; fiscal drag is drawing more and more taxpayers into the net and many people experience fluctuating incomes or are married to a higher rate taxpayer. The government could find that a restriction of tax relief could end up affecting many more people (voters) than it anticipated.”
As McPhail says, all this uncertainty can boost the amount people put into a pension. Our view is that the risk to higher rate tax relief is very real and, if you are in this group, the best way to plan against this possible change is to invest more. That is if you can afford it and don’t need access to the money until you retire.
There may be less you could do to plan for any change to the lump sum rules or amount. The Government could, for example, bring a restriction for certain age groups that might not affect older investors and avoid what would probably prove to be a huge amount of political flak. But this is only so much educated guess work. If you were planning to leave all or most of your money invested but might change your mind, we strongly suggest you get advice before altering your strategy. And of course so far, this is all only a debate not a policy proposal.
Finally if you are paying basic rate tax, who knows, but the system might change so you get more in your pension.