Rumours are once again mounting that the Chancellor is gearing up to cut tax relief on pensions in next week’s Budget. Speaking at the annual IMF meeting in Bali earlier this month, Philip Hammond described the tax breaks offered to retirement savers as “eye wateringly expensive.”
Tom McPhail, head of policy at Hargreaves Lansdown says: “It is rumoured the UK Treasury has a small red box on the wall, with a glass lid inscribed ‘In case of Budget emergency, break glass’. Inside it keeps the UK’s pensions tax relief.”
“With spending promises for the NHS and elsewhere to be honoured, the tax reliefs handed out to pension savers are once again under scrutiny. Hammond has called out the pension system in his speech to the IMF conference, so he’s obviously got a tax raid in mind.”
Here we take a closer look at the pensions ‘cookie jar’, ask what options the Chancellor has and how likely he is to strike.
1. Reduce tax relief on pensions contributions
This is the most radical option open to the Chancellor. Currently pension savers get tax relief on pensions contributions equivalent to the rate of income tax they pay. This means it only costs basic rate taxpayers £80 to save £100, while higher rate payers only have to stump up £60 to save the same amount.
Not only is this expensive (a net of cost of £25,100m in 2016/17 according to HMRC), but critics also argue that it’s unfair because higher rate tax payers get more tax relief than those that pay the basic rate.
The Chancellor could reduce this cost substantially either by scrapping higher rate tax relief or introducing a new flat rate.
Tom Selby, senior analyst at AJ Bell says: “If the Chancellor’s objective is to slash the cost of pension tax relief – perhaps to boost funding for the NHS - we are more likely to see higher-rate tax relief scrapped altogether, rather than the introduction of a rate that sits somewhere in-between the current basic and higher rates.”
“However, a flat rate of pension tax relief at 20% is the nuclear option for the Chancellor and could do untold damage to the fragile pension savings revolution being nurtured through automatic enrolment.”
Mr Selby points out that a 30-year-old higher rate taxpayer, investing £500 a month into a pension would see a whopping £114,987 wiped off his pension by age 65 if higher rate tax relief was scrapped.
While this option could be something of a money spinner for Spreadsheet Phil, it would take a brave politician to implement such bold move.
It was long mooted that former Chancellor, George Osborne, would radically reform pensions tax relief when he was at number 11, but plans were dropped ahead of the March 2016 Budget.
Mr McPhail says “this big change which would upset lots of people including back-benchers, decision-makers in businesses and those aspiring to move into the higher wage brackets. It’s technically complex to deliver due to the quirks of occupational scheme administration. The only arguments in favour of this radical solution are that it could raise quite a lot of money, and many agree the present system of paying the most tax relief to the highest earners looks, well a bit wrong really.”
2. Reduce the pensions annual allowance
At the moment retirement savers can put away 100% of their earnings up to a maximum of £40,000 a year.
Although the allowance has already been slashed substantially from a high of £215,000 when it was introduced in 2006, Mr Selby says it could be a more socially and politically acceptable way of cutting the government’s pension spend.
“One of the main criticisms of pension tax relief is that it mainly benefits wealthier savers who can afford to make large contributions. Reducing the annual allowance would be the quickest and simplest way to control the cost of pension tax relief and would only target the highest earners, making it socially and politically easier to implement.
“The Chancellor could cut the allowance to £30,000 or even £20,000 to align it with the annual ISA allowance. Even at the lower level of £20,000 people would have to find £16,000 a year to put in their pension to hit the cap, with basic-rate tax relief grossing it up to £20,000.
“For most people that is a very large amount to save and it would only take someone 25 years to build a £1million pension fund, assuming 5% growth per year. Furthermore, carry forward rules mean savers with patchy contribution records – for example those who are self-employed – would still have flexibility to make up for lost time saving into a pension.”
Commenting on the option, Mr McPhail says it would be “easy to do, mostly affects higher earners, would raise perhaps a few hundred million pounds, depending how low the Chancellor squeezed the allowance. If he cut it to £35,000 many would see this as a bullet dodged; if he cut it to say £20,000 he’d upset an awful lot of people.”
3. Reducing the Money Purchase Annual Allowance
Following the pension freedoms in 2015 it’s possible to take cash out of your pension from age 55. However, should you take taxable income out of your pension the MPAA will see the amount you are able carry on paying into your pot cut to just £4,000 a year.
Mr Selby says: “Conceivably the Chancellor could reduce this to zero for anyone who has made a withdrawal from their pension. This option would be highly controversial, however, because working patterns are changing, with people increasingly looking to stay in employment – perhaps on a part-time basis - in retirement and continue paying into a pension. It also feels grossly unfair to impose such a draconian penalty on people simply for using the pension freedoms in the way the government intended.”
He adds: “However, the Chancellor has form here having previously cut the MPAA from £10,000 to the current level of £4,000 despite there being no clear evidence of abuse.”
4. Reducing the lifetime allowance
In addition to limiting how much you can put in a pension each year, the government also limits the amount your pot can grow to with the lifetime allowance. In April this year it was increased from £1million to £1.03million.
Mr Selby says: “Reducing an allowance that has just seen its first inflation-linked increase would seem odd and risks severely hitting vast swathes of middle Britain – particularly those in the public sector with generous defined benefit schemes. And while £1.03million sounds like a lot of money, it would currently only buy an inflation-linked single-life annuity worth about £30,000 for a healthy 65-year old – a decent annual pension but hardly a king’s ransom.”
He adds: “That said the Treasury might feel reducing the lifetime allowance to £750,000 – which still sounds like a huge amount of money to most people – is politically more straightforward than other options open to it, so another cut can’t be ruled out.”
5. Reducing the annual allowance taper
Currently the highest earners face tighter restrictions on their pension saving. Following the introduction of the taper allowance in April 2016, anyone with a taxable income over £150,000 sees their annual allowance reduced by £1 for every £2 earned over that threshold.
Mr McPhail says this could be an easy win for the Chancellor. “By design this is targeted at higher earners, effectively it only applies to those with incomes over £150,000. The Chancellor could cut this to perhaps £125,000 and there would be little sympathy for the hundreds of thousands affected by it. Easy to do, politically attractive, it wouldn’t raise a huge amount but it would still be useful.”
He adds: “As an alternative, the taper could be applied more aggressively; currently the annual allowance is removed at a rate of £1 of allowance for every £2 earned, meaning the allowance is reduced to its minimum of £10,000 once someone’s income exceeds £210,000. This could be tweaked, for example so it applies at a rate of £2 lost for every £3 earned.”
6. Restricting carry forward rules
Under current rules savers can ‘carry forward’ any unused pensions allowance for the last three years. This could potentially see a saver put away £160,000 in one year.
In order to save cash, the Chancellor could implement a ‘use it, or lose it’ policy.
Mr Selby says: “This would hurt people who have not built up enough pension savings and are now in a position to do so – including potentially the self-employed. While this could present some difficulties politically, a pension contribution of £160,000 in one year is beyond the comprehension of most people, so this is potentially another easy target.”
7. Tightening up on tax free cash
Tax free cash rules enable savers to take 25% of the pension savings as a lump sum. Although the Philip Hammond could potentially scrap or reduce this feature, the experts are agreed it could be political suicide for the Chancellor.
Mr Selby says: “This would be deeply unpopular and remove one of the key incentives for people to save via pensions. It could also be hideously complicated if the Chancellor chose not to apply the change retrospectively.”
Mr McPhail takes a similar view. “The tax-free lump sum, usually 25% of accumulated pension savings, makes no sense - except everyone loves it. Remove or reduce it at your peril. Many people will be relying on it for existing spending plans or to pay off their mortgage, so any curtailment would have to be introduced slowly and progressively. Which means it couldn’t raise much money in the short term. Any move to cut it would also do significant damage to investors’ confidence in the long-term stability of the pension system.”
8. Pension death benefits:
Following the introduction of the pension freedoms in April 2015, the 55% death tax on pensions was scrapped. Subsequently, anyone who dies before the age of 75 can now pass on a pension entirely tax free. If they die at age 75 or over, beneficiaries only pay income tax at their marginal rate.
Mr Selby says: “It’s currently one of the most generous elements of the pension system, yet is not widely understood by pension savers and so in many cases is not an effective incentive to save. Combine this lack of awareness with the fiscal pressures currently facing the Chancellor and it is not hard to conclude the current system could come under review.”
But Mr McPhail says the Chancellor will need to tread very carefully. “Generally speaking Tory ministers know better than hike up inheritance taxes. However, we live in unusual times. This generous treatment may be distorting the retirement income market and encouraging investors to ‘hoard’ money in their pensions.”
He adds: “Pension freedom has proved immensely popular. A modest tax charge on death, to apply in the future could bring in substantial revenue over time; it would however confirm everyone’s worst suspicions about untrustworthy politicians.”
(All likelihood figures supplied by AJ Bell)