The Government is facing a large hole in its finances, and while it’s not yet acknowledging the elephant in the room, this almost certainly means tax rises in the near future.

The Conservative election manifesto rules out rises to income tax, National Insurance or VAT, which are the three big levers the Chancellor could otherwise pull. That leaves the burden falling squarely on other areas, and pensions could be one of them.

HOW DOES THE SYSTEM WORK?

The current system of pensions tax relief is costly, and favourable to higher earners. That’s because when savers put money into a pension, they get a top-up from the tax man – effectively the tax they would otherwise pay if they drew that contribution as salary.

Each £100 contributed to a pension costs a basic rate taxpayer £80, a higher rate taxpayer £60, and an additional rate taxpayer £55.

The growth and income that contribution generates is free from tax while it is in the pension wrapper. This is more beneficial the more you earn.

When you come to take money from your pension, 25% is tax-free. The remaining 75% is taxed at your marginal rate of income tax. Once you have used up your £2,000 annual dividend allowance, income is taxed at 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers, and 38.1% for additional rate taxpayers.

Being taxed on some pension withdrawals isn’t as bad as it sounds because many people will find themselves dropping down a tax band when they retire.

For instance, a higher rate taxpayer in working life is going to drop down to being a basic rate taxpayer unless they have a retirement income of £50,000 or more, based on current tax bands. Along with the 25% tax-free cash, it’s this downhill tax gradient which makes pension contributions such an attractive proposition.

But by the same token, taking away higher rate relief on pension contributions looks pretty tempting for the Government. It would save them billions each year, and wouldn’t necessarily be too much of a drag on the economy in the immediate future, because it could be implemented in a way which reduces retirement income, rather than draining expenditure in the here and now.

It would also tick the box of progressive taxation because it places the burden on the broadest, wealthiest shoulders.

MAKE THE MOST OF THE CURRENT SYSTEM NOW

For the moment, higher rate and additional rate taxpayers can enjoy the benefits of higher and additional rate relief on their pension contributions, and it is perhaps a good time to make hay while the sun is shining.

You can currently contribute up to £40,000 a year into a pension unless you are a very high earner or have already started to take pension benefits.

Within this annual allowance, there is also a limit on the level of personal contributions you can make and benefit from tax relief, which is 100% of relevant UK earnings. Broadly, this includes earned income such as salary and bonuses, but not investment income such as property.

However, you won’t receive any more in higher rate tax relief than the higher rate tax you have paid in the year. The same goes for additional rate taxpayers.

For instance, if your total income is your salary of £60,000, you only pay higher rate tax on the £10,000 that sits in the higher rate tax bracket, currently starting at £50,000.

In this example, £10,000 is the maximum amount you can contribute while also getting higher rate tax relief. Contributions above this amount would still attract basic rate tax relief, usually up to the £40,000 cap. It’s important to factor contributions to your workplace pension into this calculation too.

UNUSED ALLOWANCE

You might also want to use the carry forward provision, which allows you to utilise unused annual allowance from the previous three years.

At £40,000 a year, that’s potentially an extra £120,000 you might be able to contribute on top of the £40,000 allowance for this year. It’s still the case that you would only receive higher rate relief for higher rate tax you have paid in this tax year, however.   

This provision therefore only makes sense for very high earners who have lots of their annual income subject to higher rate or additional rate tax.

WORRYING ABOUT NOTHING?

Now it’s fair to point out that higher rate tax relief on pensions is like a cat with nine lives. There has been continuous speculation over most of the past 10 years that it’s going to get the chop, but it still lives to tell the tale.

This is probably because it’s such a toxic subject for politicians to address, not to mention fraught with difficulties when it comes to implementation.

That may well prove to be the case this time around, but the pandemic has placed significant pressure on government finances, and something must give.

Unlike previous administrations of the last 10 years, the current Government also has a big majority in the House of Commons to play with, which gives it greater scope to push potentially unpopular policies into legislation.

Sounding the alarm over pensions tax relief does feel a little like being the boy who cried wolf. But we should remember that at the end of that fable, the fearful canine does actually show up.

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