Pensions are a crucial part of any tax-efficient financial plan, yet most people don’t fully understand their role in protecting your savings and investments from tax. In part, this is because the rules around the tax treatment of pension savings have changed several times in recent years, leading to a more flexible, but more perplexing, system. Here we’ll explain the basics.
Tax treatment of pensions
Pensions work on the principle of deferring income earned in your working life to provide an income after retirement.
The current system offers tax relief on pension contributions so that tax is instead paid when an individual retires and draws an income from their savings. The rules provide tax incentives for both individuals and employers to save into pensions, to encourage people to take advantage of pension saving towards their retirement income. Individuals receive tax relief on their pension contributions at the rate of income tax they pay: basic rate taxpayers receive 20%, higher rate taxpayers receive 40%, and additional rate taxpayers receive 45%.
The current tax system can boost the amount of money taken from a defined contribution (DC) pension after tax is taken into account. A higher rate taxpayer, earning £60,000, would receive around half as much again (52%) from their savings from the advantages of the current tax system.
Recent changes to the pension system
While the tax treatment acts as a financial incentive for saving, the obligation to use such savings for retirement income was removed in the 2014 budget.
New rules were introduced to give pensioners complete freedom to draw down as much or as little of their pension pot as they want, anytime they want. 25% of their total pension savings could be withdrawn tax-free, and the remaining 75% would be taxed at their marginal rate of income tax for that year.
Pensions could now, for example, be used as a tax-efficient vehicle to pass on wealth through inheritance.
This weakened the link between the incentive offered and the behaviour it is intended to encourage. Pensions could now, for example, be used as a tax-efficient vehicle to pass on wealth through inheritance.
Costs of the current system
Tax relief added to people’s pension savings is paid by the government, and the cost has grown significantly over recent years as people use the current system to their advantage.
The cost of income tax relief on pension contributions has increased from £14 billion in 2000 to over £30 billion more recently. Including the cost of National Insurance contribution relief, the cost to the government was over £53 billion in 2017-2018. To add some context, HMRC income tax receipts have risen from £108 billion to £180 billion over the same period.
Around two-thirds of the value of tax relief on pension contributions goes to individuals in their 40s and 50s, while less than one-third is taken by those in their 20s and 30s.
Restrictions in the current system
To help control the cost of pension tax relief, there are restrictions in place on those making high levels of contribution and those with high levels of savings.
The annual allowance is a limit of £40,000 on contributions that an individual can claim tax relief on in the current tax year.
The lifetime allowance (LTA) is a limit on how much an individual can withdraw in pension benefits in their lifetime before paying a tax penalty. For those without pension protection, the LTA is £1,073,100 in the current tax year.
These restrictions act to even the distribution of the benefit, by curtailing the advantages to those able to make large contributions and who have accumulated high levels of wealth.
Alternatives to the current system
Changes to the pension system have been frequent in recent years, so it’s always sensible to consider what upcoming changes might affect your retirement savings. Particularly in the context of the COVID-19 pandemic and economic fallout, there’s a likelihood that the government may need to reduce its costs when it comes to tax relief on pension contributions, to allow for more spending elsewhere.
The most common idea is a flat rate of income tax relief rather than the current, progressive rate of relief.
Various alternatives have been discussed, but the most common idea is a flat rate of income tax relief rather than the current, progressive rate of relief.
Currently, the aggregate rate tax relief on all pension contributions is 32%. If the flat rate of income tax relief is set at less than this aggregate rate, it would represent a saving for the government. For example, if the flat rate were set at 25%, the saving would be 22% of the current cost to the government.
As well as cutting costs for the government, it has been suggested that this system would be fairer to those who have less to contribute to their pensions, such as those on lower incomes. The proportion of tax relief paid to basic rate taxpayers would increase from 26% to 42%.
There is currently no suggestion of if and when changes such as these might come into action, but to stay ahead of any changes to the tax treatment of pensions and other financial products, it’s best to work with a professional. If you’d like to discuss any of the topics in this article, please feel free to contact our London office.
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