Chancellor Phillip Hammond set the usual pre-Budget rumour mill into overdrive last week when he told journalists the current pension tax relief system is eye-wateringly expensive .
Most have taken these comments as a hint retirement savings incentives will be cut once again on 29 October – although the Government’s response to the Treasury Committee’s Household Finances report was lukewarm on the idea of radical reform.
Tom Selby, senior analyst at AJ Bell, considers each of the potential changes the Chancellor might be considering in this month’s Budget and what pension savers can potentially do to prepare for them.
1. Flat rate of pension tax relief
If the Chancellor’s objective is to slash the cost of pension tax relief – perhaps to boost funding for the NHS - we are more likely to see higher rate tax relief scrapped altogether, rather than the introduction of a rate that sits somewhere in-between the current basic and higher rates.
However a flat rate of pension tax relief at 20% is the nuclear option for the Chancellor and could do untold damage to the fragile pension savings revolution being nurtured through automatic enrolment.
The impact of this change would unsurprisingly be dramatic for those affected. A 30 year old higher rate taxpayer contributing £500 a month to a pension would lose just over £52,000 in tax relief by age 65 if higher rate tax relief was abolished (see table 1 below for further examples).
Such radical reform would be politically difficult – if not impossible - as it risks an almighty rebellion from the Tory backbenches. In addition, in responding to the Treasury Committee’s Household Finances report the Government said no consensus for either incremental or more radical reform of pension tax relief has emerged since the consultation in 2015.
This option therefore seems very unlikely but if higher or additional rate taxpayers are planning to make additional pension contributions this tax year, they should think about doing so sooner rather than later.
2. Reduction in the pension annual allowance
Although the Government seems to have ruled out radical reform of pension tax relief in the short-term, reducing the amount people can contribute to pensions each year remains on the table.
One of the main criticisms of pension tax relief is that it mainly benefits high earners who can afford to make large contributions.
Reducing the annual allowance would be a quick and simple way to control the cost of pension tax relief and will only target the highest earners, making it socially, if not politically, easier to implement.
The Chancellor could cut the allowance to £30,000 or even £20,000 to align it with the annual ISA allowance.
Even at the lower level of £20,000 people would have to find £16,000 a year to put in their pension to hit the cap, with basic rate tax relief grossing it up to £20,000. For most people that is a very large amount to save and it would only take someone 25 years to build a £1m pension fund, assuming 5% growth per year.
Furthermore, carry forward rules mean savers with patchy contribution records – for example those who are self-employed – would still have flexibility to make up for lost time saving into a pension.
If the Chancellor goes for this option, he could make the change immediately to prevent a flood of pension contributions.
Clearly nothing is certain here, however, and anyone thinking of radically altering their savings plans based on an off-hand quote from the Chancellor needs to consider whether this is the right thing to do.
Having said that, anyone already planning to make a significant pension contribution this tax year might consider doing it before 29 October.
3. Reducing the MPAA further
The Money Purchase Annual Allowance restricts the amount someone who has accessed taxable income from their pension can pay into their pension each year to £4,000.
Conceivably the Chancellor could reduce this to zero for anyone who has made a withdrawal from their pension.
This option would be highly controversial, however, because working patterns are changing, with people increasingly looking to stay in employment – perhaps on a part-time basis - in retirement and continue paying into a pension. It also feels grossly unfair to impose such a draconian penalty on people simply for using the pension freedoms in the way the Government intended.
However, the Chancellor has form here having previously cut the MPAA from £10,000 to the current level of £4,000 despite there being no clear evidence of abuse.
Furthermore, when Hammond implemented the cut it affected everyone, with no protection for those who had accessed their fund based on retaining an MPAA of £10,000.Anyone who is subject to the MPAA and planning to make pension contributions this year might want to get on and do so now.
4. Reducing the Lifetime Allowance
Reducing an allowance that has just seen its first inflation linked increase would seem odd and risks severely hitting vast swathes of middle Britain – particularly those in the public sector with generous defined benefit schemes.
While £1.03m sounds like a lot of money, it would currently only buy an inflation-linked single-life annuity worth about £30,000 for a healthy 65 year old – a very healthy annual pension but hardly a king’s ransom.
Furthermore, the Lifetime Allowance has been gradually sliced away from a high of £1.8m, creating huge complexity through the creation of no fewer than seven forms of protection designed to ensure the cut does not unfairly hit those close to or over the new limit.
A further reduction would only add to this complexity.
That said the Treasury might feel reducing the lifetime allowance to £750,000 – which still sounds like a huge amount of money – is politically more straightforward than other options open to it, so another cut can’t be ruled out.
If this does happen we would expect new forms of protection to be introduced to ensure those who have saved based on the exiting £1.03million allowance are treated fairly.
5. Reducing the annual allowance taper
At the moment those with an ‘adjusted income’ above £150,000 and a ‘threshold income’ above £110,000 see their annual allowance steadily chipped lower, to a minimum of £10,000 for those with ‘adjusted income’ above £210,000.
The Chancellor could reduce the point at which this annual allowance ‘taper’ kicks in, say to £125,000, restricting pension contributions for a higher proportion of high earners.
Given one of the main criticisms of pension tax relief is that the majority of it goes to high earners this could be seen as an easy target, even if the system is ludicrously complicated. If this is a target for the Chancellor, high earners need pay close attention to how it is implemented.
You would hope the Government will protect contributions already paid, but there’s no guarantee they will so high earners could be making contributions now that take them over their reduced allowance.
6. Restricting carry forward
The Chancellor could restrict ‘carry forward’ rules which currently allow savers to utilise up to three years of unused annual allowances in the current tax year – potentially generating an annual allowance of £160,000 if used to the maximum.
This would hurt people who have not built up enough pension savings and are now in a position to do so – including potentially the self-employed.
While this could present some difficulties politically, a pension contribution of £160,000 in one year is beyond the comprehension of most people, so this is potentially another easy target.
Anyone who is considering utilising the carry forward rules to boost their pension savings this year might want to do so sooner rather than later.
7. Restricting tax free cash
Currently pension savers are able to withdraw an amount from their pension (normally 25%) from age 55 without paying any tax.
The Chancellor could consider reducing this amount or even scrapping it completely.
This would be deeply unpopular and remove one of the key incentives for people to save via pensions.
It could also be hideously complicated if the Chancellor chose not to apply the change retrospectively.
This combination of unpopularity and complexity is unlikely to appeal, even if the sums that could be raised are potentially significant.
8. Pension death benefits
Anyone with a defined contribution pension, such as a SIPP, who dies before age 75 is currently able to pass on their entire unused fund tax-free to their beneficiaries – provided the money is transferred to their beneficiary within two years of them dying.
If someone dies after their 75th birthday, tax is charged at the beneficiary’s marginal rate of income tax.
This regime was introduced alongside the pension freedoms reforms in April 2015, and replaced previous rules which meant pensions were usually hit with a 55% tax charge on death.
It is currently one of the most generous elements of the pension system, yet is not widely understood by pension savers and so in many cases is not an effective incentive to save.
Combine this lack of awareness with the fiscal pressures currently facing the Chancellor and it is not hard to conclude the current system could come under review.
That said, Hammond might want to avoid raising taxes in this area for fear of them being labelled ‘death taxes’.
There isn’t much pension savers can do to prepare for this but it would have a significant impact on estate planning if the change is made later this month.
9. The need for an independent pension commission
As a broader point, the rumour and uncertainty that inevitably surrounds pension tax relief ahead of the Budget damages people's confidence in the retirement system in general.
By constantly plundering tax relief to fund immediate political promises, the Government chips away at trust in retirement saving.
Lack of saving is a long term problem and requires longer term thinking from policymakers.
We want the Government to consider establishing an independent pension commission to consider long term, sustainable pension policy, without the temptation to raid the honey pot to fund short term political ambitions.
We believe by taking this first step the Government could seek to establish cross-party consensus on how retirement saving is incentivised, building greater certainty into the UK framework.
The amount of tax relief higher and additional rate taxpayers would lose by age 65 if pension tax relief is limited to basic rate:
|Higher rate taxpayer||Current contribution amount|
|Age||£500 per month||£1,000 per month|
|Additional rate taxpayer|
|Age||£500 per month||£1,000 per month|
These articles are for information purposes only and are not a personal recommendation or advice.
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