What could the Government’s potential pension tax mean for you?

The UK government is considering a proposal for taxing pensions to help cover some of the expenses they incurred during the Covid-19 pandemic. But what does this mean for you?
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When governments around the world increased their spending to help ease the impact of the Covid-19 pandemic, the short-term benefits were immediate, but there was always the question of where this money will come from in the long run?

Although there’s nothing definite right now, there are reportedly government proposals looking to make changes to how pensions are taxed. It’s thought that the revenue generated by this tax could help cover some of the costs of the pandemic.

How are pensions currently taxed?

To better understand any proposed changes, it’s worth knowing what the current tax and tax relief are on workplace and personal pensions.

At the moment, with a personal pension, the government provides tax relief on your pension contributions up to £40,000 each tax year (or 100% of your earnings, whichever is less). This relief is currently banded, based on your tax rate:

  • Basic ratepayers receive 20%
  • Higher ratepayers receive 40%
  • Additional ratepayers receive 45%

It’s worth noting these tax-relief percentages are different in Scotland, where basic ratepayers can receive 21%, higher ratepayers receive 41% tax relief, and top ratepayers get 46% tax relief.

With workplace pensions, tax relief comes in two forms: ‘relief at source’ or ‘net pay arrangement.’

With relief at source, your employer deducts tax from your taxable earnings as normal, then they’ll take 80% of your pension contribution from your net pay and send this to your pension provider. Doing this deducts tax from your pay before your pension contribution is made. Your pension provider then claims the other 20% of your contribution in tax relief from the government, giving you a 100% contribution amount while only costing you 80%.

With net pay arrangements, your employer deducts the full amount of your pension contribution from your gross (before-tax) pay, giving you a lower tax bill and higher take-home pay. This means you’d have to pay the full amount of your pension contribution yourself, and the tax relief comes in the form of paying less tax.

What are the proposed pension tax changes?

The proposed changes would see the tiered tax-relief system on personal pensions change to a flat rate of 30% - benefiting basic ratepayers but leaving higher earners worse off. It’s worth noting that this approach is better than the previously rumoured reduction to a basic rate tax relief of 20% for everyone.

For workplace pensions, the government is considering a tax on employer contributions to pensions. At the moment, companies are legally required to pay at least 3% with no maximum limit and are able to get full tax relief on the contribution. Adding tax to these contributions may lower the amount paid to employees or cause companies to rethink their pension schemes.

There’s also speculation that the pension Lifetime Allowance (LTA) may also be reduced from its current £1,073,100, with common thinking pointing towards a limit of £800,000. While this is still a large amount, it’s likely to impact significantly more savers, especially if it remains low.

What is the impact of this?

The introduction of these tax measures reduces the incentive to save for retirement for both people and companies. Tax relief and employer contributions are a great way to encourage people to save into their pensions, without these benefits workers may save less and therefore be worse off when it comes to retirement.

If the Lifetime Allowance is also reduced, then potentially thousands of savers could experience large tax increases on their pension. This may put people off saving large amounts of money into their pension as they worry about increasing the amount of tax they need to pay. As LTA also factors in investment growth on top of contributions, if this limit is reduced then LTA could escalate from being a niche concern to one that’s far more common.

Why is the government considering this?

Nothing has been firmly decided yet, although the government does face an issue of how to raise more money for the Treasury.

Since 2020, the government has pumped billions into the economy to help support people and businesses through the pandemic. This excess spending does need to be covered, and the government may think that slight changes to pension tax could help fill that gap.

Whether or not these proposals will go ahead is likely to be announced in the next Budget speech, expected in autumn although, with coronavirus still ongoing, this could happen sooner.

It’s worth noting that it’s unlike these changes would be enforced immediately, as the rules would have to be passed into law and people need to be given time to plan and adjust.

Is this likely to happen?

Anything we write here is pure speculation, although there are a few things worth considering.

To start with, these proposals need to be agreed upon by the Prime Minister and the Conservative party before any changes can be made. This is likely to be very sensitive, as it can have knock-on political consequences. And while the next election may seem quite far away, the government are likely to try and avoid creating tension in an area that could have an impact on a large portion of the voting population.

If the state pension continues to rise next year, but savings incentives are reduced then we could see intergenerational tensions rising and questions about fairness will come about.

While pensions aren’t the most interesting things, thanks to auto-enrolment, most people are more switched on these days. That means these changes are unlikely to slide under the radar for many people and it could prove to be far more unpopular than the government expects.

It’s worth noting that pensions aren’t the only tax-efficient way to save for the future. With a Stocks and Shares ISA you may not get the tax relief on your contributions, but you can put up to £20,000 each tax year into investments. This means that any dividends or interest your investment earnings aren’t taxed, letting you keep more of your profits.

 

 

With investing, your capital is at risk, so the value of your investments can go down as well as up, which means you could get back less than you initially invested.

 

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