A Radical Overhaul of Pension Tax Relief

The Government’s consultation inviting views on whether there is a case for reforming pensions tax relief closed on 30 September 2015. Now, as we await a post-analysis response ahead of the Autumn Statement on 25 November 2015, pension experts anticipate that it is highly unlikely that the current system will remain unaltered. What does seem to be definite is that the alternative tax systems under consideration will leave higher rate tax payers saving for a pension out of pocket. What is more, time is fast running out for them to take advantage of the existing pension tax relief benefits.

Currently, people earning more than £42,386 per annum are eligible for 40% tax relief on their pension contributions. This means they are effectively adding £1 to their pension pot for every 60p they actually contribute. As many as 5,000,000 people benefit by an average of £5,000 every year. A radical overhaul of pension tax relief could involve the introduction of a simpler flat rate of relief - say 20% - regardless of how much income tax is paid and the vehicle used to save for the pension. This would see higher rate tax payers lose half of the relief they currently receive on their pension contributions. For some, this could mean losing out on their initial investment as well as on the investment returns.

Also being considered is moving pension taxation from the existing Exempt, Exempt Taxed (EET) system, in which contributions and growth within the pension are tax-free but withdrawals are taxed as income on the way out, to an ISA-style Taxed, Exempt, Exempt (TEE) system. With a TEE, contributions would be made from taxed income but pension growth and withdrawals would be tax-free when taken in retirement. Pension tax relief costs the Treasury around £35billion a year. Of course, scrapping tax relief on pension contributions on the way in would bring forward tax receipts for the Exchequer. However, for savers the resounding disadvantages of changing the current tax relief system to a TEE would be dramatic. It is reported that the loss of compound interest on the tax relief paid could reduce a saver’s pension pot by 17%. There is so much at stake and such a short window of opportunity. It is critical for higher rate tax savers to seek financial advice.