How scrapping higher-rate pensions tax relief would hit middle Britain, including NHS workers

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Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.

Given the black hole the coronavirus pandemic has blown in the Treasury’s finances, it is no surprise pension tax relief is now firmly in the Chancellor’s sights. Pension tax relief across defined benefit and defined contribution pension schemes costs the Exchequer about £40 billion a year. In this context, you can see why scrapping higher-rate pension tax relief might be attractive to a Government desperately looking for ways to balance the books.

However, whilst optically attractive, the reality of removing higher-rate tax relief on pensions is fraught with complications and it’s no surprise it has always been put back in the ‘too hard to do’ pile following previous Government reviews.

Removing higher-rate tax relief could result in additional tax bills for millions of ‘middle Britain’ workers which will be politically toxic when people realise what it means for them. There is a perception that it will only affect the very wealthy but anyone who is employed and earning over £50,000 could easily be affected if they are receiving employer contributions to a defined contribution scheme or are in a defined benefit scheme.

The impact would be most painful for people in public sector defined benefit (DB) schemes and the sad truth is that this would include front line NHS and emergency services workers who have worked so hard to help the country through the covid-19 pandemic.

If the Treasury thought the anger caused among NHS doctors by the tapered annual allowance was bad, that will pale into insignificance compared to the mutiny we are likely to see if higher-rate pension tax relief is scrapped altogether.

Furthermore, despite the early success of automatic enrolment, average retirement savings levels in the UK remain far too low.

The preference of successive Chancellors to cut retirement savings incentives and over-complicate the tax system risks undermining these vital reforms and putting an entire generation off saving for their financial future.

Given low retirement savings levels remains one of the most significant challenges facing Western society, we now more than ever need the Government to provide a clear vision for long-term saving in the UK, with a focus on encouraging more people to save more money for their financial future.

In detail: the challenges of scrapping higher-rate pension tax relief for individuals, employers and DB schemes

Personal contributions into a DC scheme

Let’s assume an individual who is a higher-rate taxpayer earning £60,000 a year pays a pension contribution personally (rather than it being paid by his or her employer) of £8,000.

They will immediately receive basic-rate tax relief at source of £2,000, paid into their pension scheme. They will then personally receive further tax relief of £2,000 when they complete their tax return.

So that equates to tax relief of £4,000 on a £10,000 gross personal contribution - or 40% tax relief.

To implement a flat rate of pension tax relief at 20%, you could simply remove the ability of the individual to receive the extra £2,000 of higher-rate tax relief through their tax return.

This would mean they end up with basic-rate tax relief of £2,000 on their £8,000 net personal contribution, equating to tax relief at the basic rate of 20% on the £10,000 gross personal contribution.

Employer contributions into a DC scheme

Higher-rate taxpayer earning £60,000 could be hit with a tax bill of £2,000

Employer contributions are deducted from pre-tax profits and give the employer relief from corporation tax. There is an added benefit for the pension member, who receives a payment into their pension without it being treated (or taxed) as a benefit in kind.

In the first example, if an individual’s employer pays £10,000 into a defined contribution (DC) scheme on their behalf (on top of paying them £60,000 salary), the employer receives a corporation tax deduction on the contribution and the member pays no tax either. This effectively grants tax relief at the marginal rate of income tax (40% in this case) to the individual when compared to the employer paying it as an additional £10,000 of salary (they get £10,000 in their pension, compared to £6,000 after tax salary)

If higher-rate tax relief is removed then it would be necessary to prevent people simply switching from personal to employer contributions via salary sacrifice. One way to do this would be to add the value of the employer contributions to the individual’s income, similar to a benefit in kind. It would result in higher-rate taxpayers receiving a tax bill, assumed to be at the rate of 20%, that they would have to pay personally. In this example, the tax bill would be £2,000.

To put it another way, the individual would need to earn an additional circa £3,400 before tax, by way of salary or bonus, to be able to pay the tax bill without dipping into their savings.

It may be possible to process employer contributions through payroll systems to achieve the desired net tax relief effect, without individuals receiving a tax bill, but that would require wholesale changes to these systems.

DB schemes

Higher rate taxpayer earning £50,000 could be hit with a tax bill of £3,744

Understanding the impact of scrapping higher-rate tax relief on DC schemes is quite straightforward, whereas it is more complicated in DB schemes. Most public sector workers – including NHS staff - are in DB schemes, whereas active DB schemes are now few and far between in the private sector.

If higher-rate tax relief is to be removed from contributions into a DB scheme, the first thing HMRC will need to do is estimate for tax purposes the value of the benefits built up or ‘accrued’ in the DB scheme by a taxpayer in any tax year.

It is not clear how the government plans to do so, but one way could be to use the established annual allowance framework.

This converts the benefits accrued during the year in a DB scheme into a monetary value.

This simply multiplies every £1 of pension accrued each year by a factor of 16. It’s probably easiest to show how this works through an example.

Example

A 45-year-old worker is in a public sector scheme that adds 2.32% of pensionable pay to the pension for each year of service (career average). They earn a salary of £50,000 a year at the start of the year and £53,000 a year at the end of the year.

The pension input amount is the increase in the notional value of their pension savings over a 12-month period, between an ‘opening’ value and a ‘closing value’.

We’ll assume that at the start of the year they had so far built up a career-averaged pension of £12,000. This is increased by a statutory figure to allow for inflation, if we use the September 2020 inflation rate of 0.5% (as current legislation requires) this gives an opening value of £12,060.

Based on their earnings of £53,000 during the year they will earn a pension for that year of: £53,000 x 2.32% = £1,230. This is added to the accrued pension to give a closing value of £13,230.

The pension input amount is: £13,230 - £12,060 = £1,170 x 16 = £18,720

The value of the accrual could be treated as income and, assuming consistency with the DC model and a flat rate of tax relief was set at 20%, this would lead to a tax bill of 20% x £18,720 = £3,744.

These articles are for information purposes only and are not a personal recommendation or advice. How you're taxed will depend on your circumstances, and tax rules can change.


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Written by:
Andy Bell - Chief Executive

Andy co-founded AJ Bell in 1995, having spent a number of years working within the financial services sector. Graduating from Nottingham University in 1987 with a first class degree in Mathematics, he qualified as a Fellow of the Institute of Actuaries in 1993 and has built AJ Bell into one of the largest providers of low-cost, online investment platforms and stockbroker services in the UK. Andy is the principal driving force behind the business, and his focus is increasingly on future strategy and growth opportunities.