Beware: the government could cut tax relief on pension contributions

Will chancellor Rishi Sunak take the axe to tax relief on private pension savings? Successive chancellors have been rumoured to be considering such changes, only to desist. But there is growing concern in the pensions industry that Sunak might see the need to repair the public finances following Covid-19 as providing the cover he needs to act.

Pension-tax relief is certainly a tempting target. It cost the Treasury £21.2bn in the 2019-2020 financial year, the last for which data is available. And it is a relief that is more valuable to the wealthy: since savers get the relief at their highest marginal rate of income tax, higher-rate taxpayers get twice as much support when making the same pension contribution as basic-rate taxpayers.

Total abolition looks out of the question for any government, let alone one that professes to be an ally of savers taking personal responsibility for their financial futures. But there is a reasonably straightforward reform that would enable the chancellor to reduce the cost of pension-tax relief while simultaneously arguing that he is redistributing resources towards middle-income voters and the less well-off.

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An extra 5%

The idea would be to introduce a flat rate of relief that everyone receives, irrespective of what income-tax rate they pay. Analysis suggests that a flat rate set at 25% would save the Treasury around £6bn a year.

And while netting that very useful windfall, the chancellor would be able to point out that anyone on the basic rate of tax would be receiving an extra 5% of relief on their savings.

The big losers in such a scenario are savers who pay higher-rate or additional-rate income tax. At present, making £10,000 of pension contributions over the course of a year costs these savers only £6,000 and £5,500 respectively. With a 25% flat rate of relief, they would have to find £7,500 to reach the same level of total savings. Those not in a position to make up the shortfall would have to settle for lower pensions later in life.

Members of defined-benefit pension schemes might also run into problems. Their retirement benefits are guaranteed, but in calculating the cost of providing that promise, employers bank on tax reliefs at their current levels. With less relief on offer to some members, that might prompt further reviews of what is affordable.

Still, do not be surprised if the chancellor puts the objections of these groups aside. The Treasury has had an eye on higher-rate pensions relief for many years, but lacked the nerve to make a grab for it. Covid-19 might prove to be the once-in-a-lifetime opportunity to pounce.

In that case, wealthier savers may want to consider increasing pension contributions sooner rather than later. Some pension experts believe new tax-relief rates would have to be phased in over time; others point out that the announcement of reform would spark a “buy-now-while stocks-last” rush to make contributions while higher-rate relief is available. The chancellor may choose to pre-empt that possibility by making changes straight away.