Would moving to flat rate pension tax relief be fairer to low earners? ROS ALTMANN replies

Fairer system? Should all savers get pension tax relief at the same rate

It seems unfair to me that the well off can save into a pension fund and get 40 per cent tax relief, but the lower earners can only get 20 per cent tax relief.

Does the new government have any plans to address this? I think a 33 per cent tax relief for all pension contributions would be fair.

Ros Altmann, a former Pensions Minister who now sits in the House of Lords, replies: Government spends over £70billion a year on pension tax breaks.

These are enormous sums which need to be spent wisely.

The vast majority of this cost is tax or National Insurance foregone on contributions (with small amounts coming from tax-free income and capital gains for all pension funds).

Many people believe the current system does not represent good value for taxpayers, especially as British pension funds invest mostly overseas, so the money helps other countries, rather than our own.

It is also suggested that pensions tax relief works the wrong way round.

The highest earners receive far more than the lower-paid for each pound they put in. 

From a social perspective, one would think lower earners need most help to make pension contributions as they struggle more to set aside money for their long-term future than high-earners.

However, with any progressive tax system, where those on higher incomes pay higher rates of tax, a system based on tax relief will be more generous to the higher-paid.

It may seem counter-intuitive to give a more generous subsidy for those with the highest incomes.

At the very least, one might think it is fairest to give the same taxpayer top-up for the same amount of contribution, regardless of someone’s income.

How does basic rate pension tax relief work now?

Consideration has been given to restricting tax relief to basic rate for everyone.

This sounds very simple in theory and here is how it is supposed to work.

Lady Altmann: The Government spends over £70bn a year on pension tax breaks – an enormous sum which needs to be spent wisely

If basic rate tax is 20p in the pound, as now, the way tax relief is calculated means everyone would receive a 25 per cent bonus on their own contributions. 

I know this sounds confusing, so let me try to explain why.

For each £1 going into your pension, 20p would come from tax relief (the 20p in the pound tax that is not paid).

For every £100 going in, £20 would come from taxpayers. 

So, if you contribute £80 to your pension fund, taxpayers add another £20.

This amounts to a 25 per cent uplift on your own money (20 out of 80 is 25 per cent).

How does higher rate pension tax relief work now?

If you are a 40 per cent taxpayer (earning over £51,270 a year), then 40p in every £1 contributed to your pension effectively comes from taxpayers.

In other words, each £100 going into your pension fund has only cost you £60, with the other £40 coming from tax relief.

The ‘bonus’ added to your pension fund is therefore worth 66 per cent (40 is 66 per cent of 60). Much better than the 25 per cent for lower earners.

This tax relief system has several drawbacks. For example, whenever the Chancellor changes tax rates, the amount of incentive given by tax relief automatically changes.

Lower tax rates mean less money going into your pension, but an increase in tax rates gives you more.

Does pension tax relief currently work as intended?

Tax relief is supposed to be an incentive provided by the rest of society to encourage people to pay into pensions.

This is desirable, from a social perspective, because it can reduce future taxpayer burdens of old-age support; help pensioners enjoy a better retirement lifestyle; and traditionally pension funds were expected to support their domestic companies and economy as a reliable long-term investor base.

This could give good long-term returns and increase domestic investment to support financial markets and growth.

Of course, in order to be an effective incentive, it needs to be generous enough to be attractive and also needs to be known about.

If a generous incentive is available, but people don’t know about it, it will not be very effective. This is currently the position.

The whole tax relief arrangement has significant complexities, changes over time have been confusing and the administration difficulties have been under-recognised.

Most people have no idea what they get from tax relief.

Would flat rate pension tax relief work better?

Restricting pension tax relief to just the basic rate for everyone sounds appealing in theory.

In practice, however, it would create administration havoc for most pension schemes.

There are two different systems for administering tax relief – ‘Net Pay’ and ‘Relief at Source’. 

Each is complicated in different ways.

In a Net Pay scheme, the pension contribution is automatically adjusted to add the tax relief at each person’s marginal rate.

Relief at Source schemes just add basic rate relief, so those on higher incomes need to claim their higher rate relief from HMRC.

All defined benefit schemes (including those for millions of public sector workers) and many defined contribution schemes, particularly new MasterTrusts, operate on a Net Pay basis, but other defined contribution pensions (including Nest and most insurance company DC pensions) use Relief at Source.

It would be easier to restrict to basic rate relief if everyone used Relief at Source, but the majority of schemes, both old and new, use Net Pay.

Changing administration processes would be fraught with difficulties and costs.

On top of this, there are even more complications to address when considering changing the current system.

Part of the costs of tax relief stem from employer contributions, which receive corporation tax relief, and also National Insurance relief.

This has caused widespread adoption of ‘salary sacrifice’ arrangements, which help reduce employer pension costs by taking advantage of the National Insurance relief.

Under salary sacrifice, employers ask workers to take a lower reported salary, in exchange for higher employer pension contributions, without reducing actual take-home pay.

The calculations are fiddly and complicated, but once the salary sacrifice arrangements have been put in place, it can be extremely costly to change the entire payroll calculation system to remove it.

So, introducing a new flat-rate pension incentive is not straightforward.

Some have argued just to remove the National Insurance relief (which costs about £10billion a year). But this would create problems for all members of salary sacrifice schemes.

Got a tax question? 

Heather Rogers, founder and owner of Aston Accountancy, is This is Money’s tax columnist.

She answers your questions on any tax topic – tax codes, inheritance tax, income tax, capital gains tax, and much more.

Check out her previous columns to see if she has already solved your tax conundrum. 

Or, you can write to Heather at taxquestions@thisismoney.co.uk.

 

Is there another way to reform pension tax relief?

A truly radical alternative has also been suggested.

This would uncouple the incentive arrangements for pension contributions from the tax system altogether.

The new system would badge the incentive as a standard ‘Government bonus’ added to your own contributions.

This might be more readily understood. 

For example, receiving the equivalent of basic rate tax relief would be explained as the Government adding 25 per cent to every contribution you make – a 25 per cent reward for pensions or ‘Buy 4, get 1 free’, regardless of how much you earn.

The reward just depends on how much you contribute.

Even this is not as simple as it sounds.

Although in theory a flat rate system of taxpayer pension incentives has wide appeal and social justification, in practice it would not be easy to put in place.

What do supporters of the present system say – should we stick with it?

Those defending the current system often argue that this is not tax relief as such, because the contributions may be tax-free on the way in, but tax is paid on the pension money taken out, so it is just tax ‘deferred’ rather than never paid.

They are concerned that higher earners would lose out.

If you only get relief of basic rate tax on your contributions, but are higher rate taxpayers in retirement, then your pension fund is being penalised, as you pay more on the way out than you benefited from on the way in.

In practice, however, this argument contains some flaws.

Firstly, most people with higher incomes and receiving higher or additional rate relief when working are on much lower incomes in retirement and often pay just basic rate tax.

That means they benefit far more from the tax relief than the amount of tax recouped later.

Secondly, higher rate taxpayers usually receive tax relief at their highest marginal rate on their entire contributions, but retirement income is only taxed at higher rate on the amount above the higher rate threshold (currently £50,270).

So this is more tax leakage.

Thirdly, everyone receives a 25 per cent tax-free lump sum in retirement, so basic rate taxpayers will never repay any of the tax relief they received.

Therefore, calling this tax deferred is not entirely correct.

Even the minority of people in a flat-rate taxpayer incentive system, who face higher rate tax in retirement and feel they pay more tax than the relief they received, have benefited from the tax-free income and capital gains earned on their fund over the years.

Should we reform pension tax relief?

Making fundamental changes to pension incentives needs careful consideration and the practical complexities and costs of unwinding current administrative systems will need time to introduce.

Change is likely to face significant opposition from many sides.

However, a simpler, fairer system could ultimately save money to the public purse, while also making it easier for people to understand how much extra will be added to their own pension contributions.

They may, therefore, better appreciate the value of putting money into a pension while younger.