A simple solution to pension tax relief

Ask anyone who does anything related to pensions these days about pensions tax relief and they will all tell you the same thing: its days are numbered. Why? Because it costs a fortune (think £35bn a year) and much of that fortune has historically been taken up by people who don’t need incentives to save – they’re likely to be doing  it anyway.

Note that 70% of pension tax relief goes to those in the higher rate tax brackets. That’s why the minister of state for pensions, Steve Webb, wants to bring in a flat rate of pension tax relief of 30% to replace the current system whereby you get relief at your highest marginal rate of income tax.

That’s something that would effectively give lower rate taxpayers a pay rise every time they saved, while limiting the benefits to higher rate taxpayers.

And it is why think tank the Pensions Policy Institute issued a report earlier in the summer entirely agreeing with the idea. However they added in a new twist – a cap on the amount of money that can be taken tax-free on retirement.

At the moment, everyone can take 25% of their pension cash out as a lump sum, entirely tax-free. PPI would like to see that percentage reduced or simply capped at £36,000 for everyone.

I can see the arguments for all this – the current relief system seems needlessly expensive. But the solutions on offer all seem bizarrely complicated when – to me at least – the solution is very simple.

If we must do something (and it appears we must always do something), why not just limit everyone to a certain level of pension tax relief by capping the amount of money that can be paid into a pension over a working lifetime?

We could get rid of the ludicrous life-time allowance system, which penalises people for investing well (see my previous posts on this) and instead cap contributions, and hence the cost of relief.

Think of the point of pension tax relief in the first place. It’s to encourage people to save enough so that they won’t be a burden on the taxpayer in their old age.

The priority of the system should then be to incentivise people to save that much inside a pension, but not to waste public money by incentivising them to do much more. Which brings us to the key question – how much is enough?

I’ve noted this before, but I suspect the answer is enough to generate an income of something in the region of £20,000, so around £4-500,000.

I accept that this isn’t as straightforward as it sounds (you’d have to inflation link the limit and it would have to be firmly applied to public-sector pensions as well as private sector pensions), but it is an awful lot more simple and significantly cheaper than most of the other ideas on offer.

  • mr clyde

    Completely agree. Tax relief on Pension savings isn’t some moral absolute, it is an incentive for people to take responsibility for themselves and remove a burden from the state. I think a 20% relief on a lifetime contribution up to around £500k is just about right.

  • Marko

    This idea would put rocket fuel under house prices. Why would wealthy people continue to save money in the traditional tax efficient vehicles of SIPPS and ISAs once they have breached the limit?

    Buy a property under a spouses name and then a rental property for each kid and any other siblings you care for then if they are lower rate tax payers take the income tax free or lower rate tax, no national insurance.

  • mr clyde

    …only because the tax reliefs available in the property sector are even more unjustifiable that the tax reliefs available on pensions. Completely remove the opportunity to ‘flip’, and rationalise capital taxes, and watch property prices collapse. (No chance of that happening then!).

  • 4caster

    Personal pension pots are taxed at the time of withdrawal – or upon death if the estate is large enough.
    Therefore they should never be taxed at the time of contribution, because that constitutes double taxation. Only a socialist state would claim to be the judge of how much an individual should be allowed to stash away in his or her pension fund. Oh for the freedom of the individual!
    The only exception to this is the lump sum, whereby a quarter of the pension pot around the time of retirement can be taken tax-free. It is now about the only incentive to encourage earners to save more, and thereby fund their own retirement instead of spending all their income as it comes in, and then spongeing off the state in retirement.
    Relief at one’s marginal rate helps high earners the most. An unlimited flat rate tax relief at 30% would encourage basic rate taxpayers, but non-taxpayers do not have the wherewithal to take advantage.

    • mr clyde

      4caster – Pension pots are not taxed at withdrawal, withdrawals are taxed at withdrawal and at the marginal tax rate. So contributions paid in at 40% relief and withdrawn at 20% tax get a nice government subsidy. In fact, the idea of the 25% tax free allowance is to ensure that the bulk of the original contributions are returned tax free. So another subsidy. The pot is allowed to grow free of CGT and subject only to a dividend tax of 10%, more subsidy. And finally, if you are rich enough and canny enough and build up a nice pot that doesn’t need to be vested i.e. put into drawdown before you die. The whole lot goes to your beneficiaries completely tax free and outside your IHT allowance. Excepting CGT relief on primary residences, SIPPs are currently the best tax avoidance scheme available, if you’re rich enough!

      • mr clyde

        PS. Which I think is the point MSW is making.

  • Clive

    “That’s something that would effectively give lower rate taxpayers a pay rise every time they saved”

    Oh, great, another benefit (and people wonder why this country is broke)