With the Autumn Budget due, there are (as always) a lot of rumours flying around about what might or might not be in the Budget about pensions and in particular about the way that pensions and tax relate.
The big talking points, as usual, are tax free cash and tax relief on contributions – will the first be removed or restricted and will the second by limited or changed to a flat rate.
Pensions currently work on the basis of a tax benefit when paying in, a tax benefit while the money is in the pension and ultimately tax to pay when you take money out. So it’s sort of a deferral of tax however, the expectation for many is that any tax rate that they pay in the future when retired will be lower than the rate they are paying now when they are working.
The tax benefit while paying in comes in the form of tax relief on the contributions. Paying personal contributions, the principle is that you pay 80p in every £1 of contribution and the Government adds the other 20p in to the pension for you. If you pay higher rates of tax (40% or 45%) you can then claim the £1 in your tax return and get a further reduction in the tax you pay (20% or 25%).
Since tax relief on contributions benefits higher earners more than lower earners, there are limits on the tax relief available through an Annual Allowance and the possibility of this Allowance reducing if you earn over £200,000 a year.
Although ultimately you are supposed to pay tax when you take money out of a pension, the principle is that you are allowed to take 25% of the value of your pensions as a tax free lump sum. This way even if you pay basic rate tax when working and basic rate tax when retired, there is still a benefit to using a pension to save for retirement.
Since the ability to take tax free cash out is likely to benefit higher earners more than lower earners, there is a limit on the amount of tax free cash that can be taken out overall from all pensions combined. The latest limit is the Lump Sum Allowance (£268,275), which is in principle the same as it was under the old Lifetime Allowance.
Indeed, and I think this is quite an important thing to bear in mind.
Depending on who you agree with, there may or may not be a Supermassive Black Hole in the budget, which may or may not need to be filled by raising tax revenue or cutting spending, but there are also some principles at play.
One of these principles is that legislation should not be retrospective. A grey area is the concept of retroactive legislation (“we can change Inheritance Tax rules because you haven’t died yet”). However, with pensions, any tax relief has been given, and in many pensions the entitlement to tax free cash has been earned as part of the contract. If this principle is followed, any changes should only happen to what has yet to come, which is why since 2006 each change has been accompanied by the ability to protect what you already had.
Therefore the first point I would make is that it is highly unlikely that anyone will simply lose the ability to take tax free cash from a pension.
The last time that losing your entitlement to 25 tax free cash was touted by the press, what was actually happening was the introduction of the Lifetime ISA : a Government bonus to boost your savings, no tax on the investment, no tax when you took it out, but limits on when and why you could take it and keep the bonus. Who needs 25% tax free cash entitlement for an investment that allows 100% to be taken without any tax?
The second point is that the way that the abolition of the Lifetime Allowance was somewhat rushed, there are numerous errors in the pension legislation that we have currently that are supposed to be being fixed this year, legislation that in the main affects people taking their tax free lump sums.
Although there may be a temptation to further reduce the tax free cash entitlement from a pension, not only is it the most commonly known benefit of a pension but also adding further changes on top of the existing errors is likely only to create more work than the additional revenue would justify.
Limitations on tax relief have been the cause of some of the most heated debates since Covid.
The Annual Allowance to which was added Tapering for higher earners, was one of the major drivers of debate around the ability of the NHS to function properly. Members of the NHS pension scheme were having tax charges levied to claw back tax relief, or in some cases notional tax relief, on the increase in their pension benefits each year. This led to claims of Doctors selling or mortgaging their houses to pay the tax charge and being driven to retire early or reduce hours because what is the point of working just to pay tax?
Although there may be valid political, fiscal or social reasons for limiting the amount of tax relief given away on pension contributions, or moving to a fixed rate of say 30% relief regardless of what rate of tax you pay, there are also valid reasons why not.
The elephant in the room of UK pensions has for a long time been the public sector pension schemes. Defined benefits, highly subsidised, State guaranteed inflation-proofed lifetime incomes that the vast majority in the private sector can only dream of. They give members a defined benefit for each year of service and this is translated into a notional contribution which, if higher than the Annual Allowance or Tapered Annual Allowance, also gives members a tax bill.
They can pay that bill by asking the scheme to pay it and having a reduced benefit, but as it’s one of the main things that got Doctors up in arms, further changes here could cause problems. It has been suggested that the simple thing to do would be to exempt people like Doctors from any reduction in the tax relief. However, the existence of the schemes already makes for a two-tier pension system, so if that pension gap is widened even further then boy will the Government come in for criticism from everybody in the private sector.
Always a tough question. As those who know me will know, I believe in a lot of things but not the ability to predict the future. Although my view is that fiddling further with tax free cash or tax relief isn’t sensible, certainly at the moment, we all know that sense and politics don’t always go hand-in-hand.
An easier change, albeit one that would raise less revenue and raise it less quickly, would be to change the death benefit position of pension funds. Back when I started in financial services, pensions were used to buy annuities. On some of the pensions that I saw the only payment on death before doing so was the amount that you had paid in over the years, not even with any interest added.
Fast forward to today and pensions are increasingly being used not for retirement income but for generational wealth transfer. One of the interesting facets of the error strewn legislation introduced in April is that if you die under the age of 75 and pass your pension to your beneficiaries as a pension rather than a lump sum, they could then take the whole pension fund out the next day free of tax no matter how large the amount of money.
If I were to bet on anything so far as pensions and the Budget were concerned, it would be that the errors in legislation will be corrected, a consultation exercises on flat rate tax relief will be announced, a requirement to take a minimum income from drawdown will be reintroduced and pension death benefits will become taxable in more circumstances, probably moving to being subject to Inheritance Tax, but with their own IHT allowance.
Having stuck my neck out here I duly expect to be proven wrong on all counts, but that’s the joy of predictions when making them doesn’t have any affect on anyone.
The levels and bases of taxation, and reliefs from taxation, are subject to change and their value depends on the individual circumstances of the investor.
