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Reforming pension tax relief

Published Monday, March 7, 2016

Looks at the current debate on pension tax relief reform

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The principle of the current system of tax relief is that contributions to pensions are exempt from tax when they are made, but taxed when they are paid out to the individual. Pension contributions made by individual employees are usually paid out of pre-salary, so tax relief is received at the individual’s marginal tax rate. The main limits that apply are the lifetime allowance (LTA) and annual allowance (AA). At introduction in 2006, the AA was set at £215,000 and the LTA at £1.5 million. Both were set to increase in stages, with the LTA reaching £1.8m and the AA £255,000 by 2010.  Since 2010, both allowances have been reduced on a number of occasions. The Government estimates that these reductions have “significantly reduced the share of pensions tax relief that goes to additional rate taxpayers” and reduced costs to the Exchequer by over £6 billion a year. (Cm 9102, Cm 9102, July 2015, para 1.5 and 2.6.) For more detail, see Library Briefing Paper SN0-05901 Restricting pension tax relief (February 2016).

However, calls for more fundamental reform have continued, partly fuelled by concerns that the current system is not effective in encouraging saving particularly among those most at risk of not saving enough for their retirement. The Government launched a consultation on reforming pension tax relief to strengthen the incentive to save in July 2015. It is expected to respond to this in Budget 2016.

Debate has focused on three approaches to reform:

  • A shift to a single-rate of relief, possibly rebadged as ‘matching contributions’ from the Government. Advocates of this approach say it would improve incentives to save for low earners and could reduce Exchequer costs. On the other hand there are those who argue that it would be expensive and complex to administer, unfair and inappropriately distort behaviour. 
  • Moving to a TEE (taxed-exempt-exempt) system where contributions are made out of taxed incomes (and then topped-up by the Government) while investment returns and any income ultimately received would be tax-free. Advocates of this approach say it could allow individuals to better understand the benefits of contributing to a pension and make the Government’s contribution more transparent. Others argue that it would be very complex in transition, could undermine pension saving and have a negative fiscal impact. 
  • Retaining the current system, with some modifications, for example regarding the LTA and AA. This would have the advantage of lower implementation costs, meaning that reforms could be delivered quickly and with minimal risk.

Over the weekend of 5/6 March, it was reported that no major reform would be announced in the March 2016 Budget (BBC news, 5 March 2016).



Commons Briefing papers CBP-7505

Author: Djuna Thurley

Topic: Pensions

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