Consider cutting tax-free cash and the annual allowance but U-turn on making pensions subject to inheritance tax – that is the advice to chancellor Rachel Reeves ahead of her Budget from a former pensions minister, Ros Altmann.
Pensions should be changed “as little as possible” in the upcoming Budget, set for 26 November, Altmann, who served as pension minister under David Cameron from May 2015 until July 2016, said.
But with Reeves facing a projected black hole of £30bn in her spending plans, and Labour’s pledge not to raise VAT, income tax or National Insurance, rumours have been circulating that pension savers are in the chancellor’s sights as a potential source of much needed revenue via Budget tax rises.
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Altmann said: “Recent weeks have seen an almost non-stop flow of suggested pension policy reforms for the upcoming Budget. Because so much public money is spent on pensions, and many commentators believe money should be redistributed away from the old to the young, several radical ideas have been proposed.
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“The chancellor should aim to change as little as possible in the near-term and avoid adding new complexities, while ideally encouraging more pension contributions to benefit British growth and investment.”
Altmann has weighed up the potential pension measures on the table.
1. Annual allowance – reduce from £60,000
One of the easiest ways to reduce the annual spending on tax relief for pensions, would be to lower the annual allowance, Altmann pointed out.
The annual allowance is a threshold which restricts the amount of pension savings you are allowed each year with tax relief to £60,000 a year. The total annual pension contribution cannot be greater than your earnings, so anyone on average earnings could not contribute anywhere near the annual limit.
“The chancellor might want to reduce this to, say, £50,000, saving some money spent on tax relief,” Altmann said.
2. Tapered annual allowance – reduce from £10,000
“The chancellor may be tempted, more for ideological ‘hit the rich’ reasons than to raise serious revenue, to reduce or even abolish the tapered pension annual allowance,” said Altmann.
The tapered annual allowance only applies to the very highest earners (earning over £200,000). Their permitted annual pension contributions reduce as their so-called ‘adjusted earnings’ increase from £200,000 to £260,000, reaching a reduced maximum of £10,000.
It would not save much money as there are relatively few top earners, Altmann suggested.
3. Money purchase annual allowance – reduce from £10,000
There is also the money purchase annual allowance, “which the chancellor may decide to reduce or even scrap altogether”, Altmann said.
The money purchase annual allowance (MPAA) is a £10,000 limit on annual pension contributions that receive tax relief for those who have already taken more than their tax-free cash out of their money purchase defined contribution pension.
Again, Altmann said this is unlikely to save much money as it only applies to a small proportion of people.
4. Limit pension allowance carry forward rules
The current system allows people who have already used their full annual allowance of £60,000 this year, to carry forward any unused annual allowance from the last three years as well.
The chancellor could decide to reduce the number of years that contributions can be carried forward, or even stop carry forward altogether for next year and save some tax relief that way. This would mostly hit the higher earners, but Altmann said would also not raise significant amounts of revenue.
Pros and cons of changing the pension annual allowances
Pros
- Easy to understand and not too complicated to administer
- Would not impact the majority of working people, as only the higher earners are likely to find their contributions restricted by these lower limits.
- Would save money in the first year and in future years
Cons
- High-paid defined benefit scheme members such as senior NHS staff would face large tax bills on their pension contributions, but introducing only for defined contribution and not defined benefit would anger higher earners in private sector
5. Cut tax-free cash
There have been strong rumours that the chancellor would like to reduce the amount of tax-free cash that people can take from their pensions. Currently, up to a quarter of most pension funds can be withdrawn tax-free and spent as you like. Unless you have a protected sum, the maximum amount of tax-free withdrawals is capped at £268,275. This could be reduced to, say, £50,000.
Pros and cons of reducing tax-free cash
Pros
Significant extra revenue for the chancellor, without hitting those with more modest pensions, so from a social equity perspective the government may find this tempting.
Cons
This change would particularly hit people relying on using their tax free lump sum to pay off a mortgage or other loans, who would now face a high tax bill to withdraw the money.
The rumours of this possible change have already caused huge amounts of money to be withdrawn from pensions, just in case the limit is lowered.
Altmann said: “Many of those taking money out now may regret this later if there is no change, while those not quite at age 55 – the minimum age that you can make such withdrawals – will be most upset if the change does happen.”
6. Impose National Insurance on pensions in payment
The chancellor could introduce a new National Insurance pension levy, perhaps at a 2% rate.
Altman said: “Average pensioner incomes in the UK are approximately £21,000 a year. Assuming say, eight million pensioners pay 2% on £9,000 of income – the amount above the personal allowance – they would each pay around £180 a year in new tax and the chancellor would receive about £1.4billion in extra revenue,” Altman calculated.
Pros and cons of imposing National Insurance on pensioners
Pros
- Chancellor receives significant extra revenue
- Higher taxes on pensioners would ‘level the playing field’ with working people.
- It could be portrayed as an issue of inter-generational fairness, which is a theme that has been very popular with this government.
Cons
- This would seem to break the government’s promise not to increase tax, NI or VAT, and would upset millions of pensioners.
7. Pension funds should use tax relief to invest in British companies or infrastructure and real assets
Altman’s proposal would be to require at least 25% of all new pension contributions to be invested in British assets – quoted companies, venture capital, start-up capital and real assets such as infrastructure, property and alternative energy.
“If pension funds want to put more than, say, 75% of their contributions in overseas assets, instead of here, they would not receive help from British taxpayers. It would be their choice. This is not mandation, it is a quid pro quo for receiving the taxpayer money,” Altmann said.
8. New tax on unused pensions that bypasses inheritance tax
Altmann has branded the chancellor’s decision last year to impose inheritance tax on unused pensions on death from April 2027 “a disastrous change”.
The Chancellor could instead, she said, consider introducing a new tax on unused pension benefits, administered completely outside the inheritance tax system, payable by the pension provider. This could be set at a level of 10%, 15% or 20%, but would apply to all unused pensions, regardless of whether the person’s estate pays inheritance tax.
“It would be a straightforward amount to collect and would raise extra revenue for the Chancellor,” Altmann said.
9. Make auto-enrolment compulsory at the minimum level – and scrap tax relief
Pros and cons
Pros
- Chancellor saves significant sums on tax relief
- With opt-out rates so low, most workers would be relatively little affected
- All workers would be treated the same, regardless of earnings, in respect of the minimum auto-enrolment levels and none would receive tax relief on their contributions. Currently, the lowest paid in net pay schemes get no tax relief and higher earners get more than those on basic rate tax.
Cons
- Could be seen as a new work tax
- Lower take-home pay
- Could add to employer cost pressures to increase contributions instead of workers
10. Scrap National Insurance relief and salary sacrifice
The cost of National Insurance relief is estimated to be around £20billion a year. Tax relief was designed to be deferred tax, which allows people to contribute to their pension without being taxed, but then they would pay tax on the pension they receive in retirement. However, allowing employers to claim National Insurance relief for the pension contributions they pay on behalf of staff, is “pure tax leakage”, Altmann said - because pensioners do not pay National Insurance on their pension income.
In addition, many employers use ‘salary sacrifice’ to pass on the savings in National Insurance to workers as well, giving an extra boost to their pension, at no additional cost.
A decision to ban the use of salary sacrifice and end employer National Insurance reliefs for pension contributions, would save billions of pounds a year, but would up-end pension administration systems and add new costs to employers who would have to change all their systems. “It is unlikely this could be introduced quickly – and could take years to be introduced,” Altmann said.
11. Abolish higher rate tax relief
Higher earners receive much more generous reliefs than basic rate taxpayers. With basic rate tax of 20%, the tax relief is equivalent to a 25% bonus added to your pension. For every £4 you put into your pension, the government adds another £1. But for a 40% taxpayer, the bonus is 66% – for every £3 you put into your pension, the Exchequer adds another £2. The deal is even better for 45% taxpayers, but the very highest earners do face the reduced annual allowances as described above.
“There have been many studies pointing out that an incentive system based on a flat-rate top up to pension contributions, rather than using tax relief, would be much fairer and would ensure the incentives are less inequitable,” Altman said.
A 25% bonus would mean everyone receives the equivalent of basic rate tax relief, so all higher or upper rate taxpayers would lose out. A 30% bonus would redistribute the £70 billion of tax and National Insurance reliefs that HMRC spends each year, so that lower and middle earners receive more help to build their pension than now, while higher earners receive less.
Altmann said: “This sounds attractive in theory, but would also be fiendishly complicated to introduce. It would probably take several years. Depending on how the new incentive ‘bonus’ would work, there could be significant long-term cost savings for the Treasury though, while enhancing its efforts to redistribute income from higher to the middle and lower earners.”
12. Turn pensions into ISAs
This option was seriously considered in 2016, Altmann pointed out, as “it would save huge amounts of money to the Treasury in the near term, because suddenly the government would not be spending any money on tax reliefs for new pension contributions”.
ISA contributions are made out of taxed income, and then there is no more tax to pay on the investment returns or on withdrawals. An ISA-Pension could operate on similar principles.
The Lifetime ISA (LISA) was an attempt to try out the concept of an ISA-Pension – where the government adds 25% to your own payments into the LISA account – but it has not proved popular.
“This radical option would, in my view, undermine pension saving,” said Altmann. “Allowing tax-free withdrawals at, say, age 60 would most likely see people cashing in their pension as soon as they can, just in case a future government changes the rules and imposes new taxes.”
