This post is designed to do 2 things. Firstly, we’ll give you a brief overview of the tax relief regime for pension contributions. Secondly, we’ll give some commentary as to where this is going politically.
How does pension tax relief work?
The tax relief on pensions is one of the things that makes them so attractive. In short, if you make personal contributions to a registered pension scheme, the Government will give you some of your income tax back.
For for every £100 gross pension contribution, you only actually pay £80 net (out of your bank account or wages). The Government tops up the other 20% (based on the current income tax rate). Therefore, for a £100 per month contribution from your wages, your pension fund will actually receive £125 – an uplift of 25%. Now what other investment can guarantee this kind of growth on day one? This tax relief is a big reason why pensions are a good way to save for the long-term (although there are some restrictions on them as well).
Higher rate income tax payers
For higher rate income tax payers, you pay income tax at 40%. You can reclaim the further 20% tax (the difference between the higher and basic rates). Therefore, for your £100 gross contribution, you would pay in £80 net from your account or wages, and then reclaim the remaining £20 through your tax return. Thus, if you pay in £100 from your wages, £125 goes into your pension pot, and you get £25 back as well through your tax return.
All this adds up to a significant benefit for all savers, but particularly higher rate tax payers.
Limits
You are allowed to pay in up 100% of your earned income, or £3,600pa gross, whichever is the greater. This means that low earners or non-earners (including children) can pay into a pension plan, and event receive contributions from a third party (say a partner or parent), and still claim tax relief.
From April 2010 the maximum allowed to be paid into a pension plan and still attract tax relief is £255,000.
Political changes
Obviously, we are nearing an election and have a massive public deficit. Therefore, the Government is trying to do 2 things: to demonstrate a clear difference between themselves and the Opposition; and to reduce the burden on the public finances of a benefit which seems to be delivered to those who least need it – i.e. higher earners.
The Government recently announced it would introduce a new income tax rate for earners over £150,000 at 50%, effective from April 2011. This would have increased the tax relief payable to such earners, so they also brought in complicated measures to stop this. The restrictions apply to all contributions for such high earners, including those made by employers, and they are also seeking to stop people from making massive contributions this tax year to pre-empt the changes next year (the anti-forestalling measures). For more information see this link to the Pensions Advisory Service website. The measures will reduce the tax relief available to earners over £150,000 so that relief will be tapered away to that payable to basic rate tax payers for contributions for earners over £180,000. If you earn over £150,000 and you already make significant contributions to your pension, you will not be penalised so long as you can demonstrate a pattern in your pension contributions of no more than £20,000pa; those looking to pay in extra in the short-term will be penalised.
Clear? That’s what we thought! The easy answer is to seek guidance from us if you think you may be caught in the new rules.
Pension tax relief in figures
Let’s look at some of the sums involved, courtesy of a recent article in the Economist and another in Citywire.
- The current tax relief regime costs £28.4 billion, or 2% of GDP
- 25% of this figure goes to the richest 1% of the working population
- Abolishing tax relief on higher rate contributions could save the state £10 billion per year.
These are significant figures, and we actually do think that some reform of pension tax relief is needed, although we could not support the proposed changes. These changes are far too complex and probably will not have the results that the Government want. We can see that many high earners, already disenchanted with pensions, will be put off pensions altogether. This may result in less take up of pensions, and less roll-out to the lower paid workforce in general. Of course, many higher earners also retain professional advisers, which will see them look to alternative arrangements (such as EFRBs) to obtain an advantage.
We would prefer to see a simplfied system of tax relief on pensions. Why not apply a level rate applicable to all earners, with a top limit on contributions? This seems the fairest way, and does not discriminate against basic rate tax payers. We realise that many people (including some clients) would not support this, but we see it as strange to give the biggest benefits to those who can most afford them. Why not simply offer everyone the same level of tax relief, and those who save more will get a greater benefit?
See our pensions section of our website.
