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Reform of pension tax relief

Published Friday, October 12, 2018

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). (Finance Act 2004 (FA 2004), Part 4).

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. (FA 2004 s218 and 228). 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 SN-05901 Restricting pension tax relief (February 2016).

Calls for more fundamental reform  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. Debate 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.

However, in Budget 2016, the Chancellor did not announce any fundamental change to the tax treatment of pension on the grounds that there was ‘no consensus’ (HC Deb 16 March 2016 c966). It announced other measures to encourage saving, such as the introduction of a Lifetime ISA, which individuals aged between 18 and 40 could open to save for a first home or to withdraw from age 60 - see CBP-7724 (November 2016).

In July 2018, the Treasury Select Committee suggested the Government return to the question of reform – and in particular that it should “give serious consideration to replacing the lifetime allowance with a lower annual allowance, introducing a flat rate of relief, and promoting understanding of tax relief as a bonus or additional contribution” (para 117). However, in its response on 12 October, the Government said that “no consensus for either incremental or more radical reform of pension tax relief has emerged since the consultation in 2015.”

Calls for the Government to address the fact that non-taxpayers in pension schemes using the ‘net pay’ arrangement do not receive the tax relief they are entitled to. There have been reports that the Government is looking at whether the move to a modern digital tax system could be an opportunity to address this.



Commons Briefing papers CBP-7505

Authors: Djuna Thurley; Richard Cracknell

Topic: Pensions

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