"This is seen by many as a fairer way of sharing this Government incentive across people of all earnings bands but would also likely produce a cost saving for the Treasury."
The chancellor is said to be “very attracted” to the idea of moving to a flat rate, which could be announced in tomorrow's spending review and would help the government recoup some of the costs of Covid-19.
Under the proposals, basic rate taxpayers would receive a boost to their pension pots. Under a flat rate of 25% tax relief, a basic rate taxpayer paying £100 a month into their defined contribution pension would see this topped up to £133.33 rather than the current £125, an extra £8.33. This means a 22 year old on average pay of £27,000 paying 4% could be £21,000 better off by state pension age.
However, a higher rate taxpayer who currently sees their £100 increased to £166.66 would see this reduced to £133.33. A 35 year old earning £60,000 paying the same 4% could lose out by £85,000 or would need to contribute an extra £50 per month initially to maintain current retirement aspirations.
Steven Cameron, pensions director at Aegon, commented: “The Chancellor is rumoured to be considering changing the system so that rather than pensions tax relief varying with your income tax rate, everyone would receive a flat rate relief of 25%. This is seen by many as a fairer way of sharing this Government incentive across people of all earnings bands but would also likely produce a cost saving for the Treasury. It would be good news for basic rate taxpayers who’d receive a more generous bonus but would create a big dent in the future pension pots of higher and additional rate taxpayers unless they increased their contributions.
“As well as tax incentives on contributions, individuals can take one quarter of their pension proceeds tax free, with the balance being taxed as income at the rate they pay in retirement. This means pensions are already regarded as the most tax efficient means of saving for retirement and the rumoured changes would make pensions an even better deal for those paying basic rate income tax.
“Most individuals paying higher rate tax when working pay basic rate income tax once they’ve retired. For them, pensions would still be very tax efficient under a flat rate 25% tax relief system. The group for whom it’s less clear are those who might be higher rate taxpayers in retirement, who might need to weigh up the pros and cons. But like all employees who contribute to a workplace pension, they would also receive valuable employer contributions offering an additional attraction.
“Before implementing a move to a flat rate of pensions tax relief, more thinking is needed on how this would work for those contributing to a defined benefit or final salary scheme. Here, the pension benefits they receive are based on their final or career average salary and not on the amount their contributions grow to after tax relief and investment growth. For consistency with those contributing to defined contribution schemes, higher and additional rate taxpayers in defined benefit schemes might see their and their employer’s contributions taxed as a benefit in kind, increasing their tax bills.”
