Pensions tax relief costs the government almost £50 billion a year, according to new figures, fuelling speculation that the chancellor will be eyeing up changes as part of her Autumn Budget.
HMRC data reveals that the net cost of pensions tax relief (income tax relief plus National Insurance relief minus income tax on pension withdrawals) came to £48.7 billion in 2022/23.
Almost two-thirds (62.6%) of the tax relief was enjoyed by higher-rate and additional-rate taxpayers, potentially making it an attractive target for a chancellor keen on redistributing wealth, cutting the benefits of the highest earners and raising significant revenue in the process.
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Steve Webb, partner at consultants LCP and a former pensions minister, comments: "There is no doubt the chancellor will be eyeing up the large price tag attached to providing tax and National Insurance relief on pension contributions. This is particularly the case when more than 60% of the cost of tax relief goes to those paying tax at the higher or additional rate."
Pensions have already been a big focus for the Labour government.
Documents released shortly after the King’s Speech set out a new Pension Schemes Bill. A two-stage pensions review was also launched by chancellor Rachel Reeves last month.
On a visit to Canada yesterday, Reeves hosted a roundtable with the so-called "Maple 8" group of Canadian retirement funds, who have invested billions of pounds in the UK economy. She said she wanted UK pension funds to learn lessons from the Canadian model and invest more in the UK.
So far, the government's measures have largely focused on making the pensions landscape more efficient and productive for savers, while driving investment into the British economy.
However, the tax perks that pension savers enjoy could also come under the spotlight in the Budget on 30 October.
While Reeves has already announced a series of spending cuts, such as making the winter fuel allowance means-tested and scrapping the social care price cap, experts warn that the Budget will likely contain more bad news.
This could include hiking capital gains tax, possibly changing inheritance tax and stamp duty, and also tinkering with pensions to raise much-needed cash to plug the fiscal deficit.
We look at how pensions tax relief works, how much it costs, and what the government could announce in its first Budget.
How much does pensions tax relief cost?
HMRC figures show that the net cost to the Exchequer of the income tax and National Insurance reliefs on pensions came to £48.7 billion in 2022/23, a £1.1 billion increase on a year earlier.
This was made up of income tax relief (£46.8 billion) plus National Insurance relief (£23.8 billion), and then minus £22.0 billion of income tax that pensioners paid when they withdrew money.
Analysis of the data by Webb highlights the extent to which the cost of income tax relief is skewed towards the highest earners, who tend to pay more into pensions than lower earners and who also benefit more because they get relief at their marginal rate of tax.
The government paid out £15.9 billion of tax relief to basic-rate taxpayers (about 37% of the total). Higher-rate taxpayers received the biggest slice, at £23.6 billion, worth about 55%. Additional-rate taxpayers received £3 billion of pensions tax relief.
If pensions tax relief was changed so that it was paid at a flat level to everyone - say 25% or 30% - this would reduce the amount that higher earners receive while also cutting the overall bill.
How does pensions tax relief work?
Savers are entitled to tax relief on money they pay into their pension pot up to an annual maximum. This is essentially a refund at your marginal rate. If you are a basic-rate taxpayer, you get 20%, while higher and additional-rate taxpayers are entitled to 40% and 45% respectively.
Most people can receive tax relief on contributions up to the value of £60,000 each tax year. This is known as the annual allowance. Note that it includes any employer contributions, as well as employee contributions.
If you are a very high earner, and your annual taxable income exceeds £260,000, you will not be entitled to the full allowance. Instead, it will be lowered by £1 for every £2 of income that you earn over the threshold.
If you don't have any earnings, the maximum limit for tax relief per tax year is £3,600. This is also the allowance for children's pensions.
Truth or speculation?
“The potential for a raid on retirement savings incentives is a rumour that usually does the rounds before a Budget,” says Tom Selby, director of public policy at the investment platform AJ Bell.
In Labour’s case, this perhaps hasn’t been helped by the tax rumours that were doing the rounds on the campaign trail. Former prime minister Rishi Sunak accused Labour of planning to introduce a “retirement tax” after the party said it would not match the Conservatives’ promise to unfreeze the personal allowance for pensioners.
Scrapping the higher and additional-rate tax relief on pensions in favour of a flat rate could raise billions for the Treasury. Estimates from the Institute for Fiscal Studies suggest imposing a flat rate of 30% for everyone could generate £2.7 billion annually.
However, in reality, reforming tax relief rules could prove challenging.
“A huge chunk of any potential savings to the Treasury from a pension tax relief raid would come from defined benefit (DB) schemes, the majority of which now reside in the public sector,” says Selby.
He adds: “If a flat rate of pension tax relief below 40% were applied on these schemes, the only way to ensure the correct level of tax relief was applied to contributions from higher and additional-rate taxpayers would be to hit those members with a tax charge likely running into thousands of pounds.
“This would therefore risk opening up a blistering row with NHS staff and civil servants at a time when many public services are already stretched to breaking point.”
Webb agrees. He says that nearly half of the net tax relief cost is on contributions made into defined benefit pension schemes, particularly those in the public sector.
If tax relief was cut, the main losers will be senior public servants, often in highly unionised sectors, according to Webb.
If tax relief on employer contributions was reduced, that could mean increased costs for public sector employers (such as hospitals and schools), unless the costs were passed on to employees - but that may not be a desirable option either.
"Raiding the tax relief pot is far from straightforward, particularly in the case of defined benefit pension schemes. It may well be that the new chancellor ends up where previous chancellors have ended up, namely finding complex technical ways to claw back reliefs from the wealthiest but leaving the majority of savers unaffected," notes Webb.
What options are available to the government?
Introducing a flat rate of 30% pension tax relief would be “the nuclear option”, according to Gary Smith, partner in financial planning at wealth management firm Evelyn Partners.
As well as proving potentially invasive to public sector defined benefit schemes, it would probably involve dismantling private sector salary sacrifice schemes, he says.
That said, other options are open to the government, such as cutting the annual tax-free pension allowance from its current level (£60,000).
“We might also see some kind of death tax applied to pension funds, as that would also remove an anomaly that think-tanks have been criticising,” says Smith.
He adds that these measures could be implemented without impacting public sector schemes.
Pensions tend to be outside the estate for inheritance tax purposes. Instead any tax levy depends on the age of the pension saver when they died, and the way the money is inherited. If they're under 75, beneficiaries can normally inherit a pension tax-free. If they're aged 75 or over, income tax may be payable.
Webb notes that one possibility is that the government could decide to leave defined benefit schemes alone and focus on the remaining £22.7 billion of relief to defined contribution pensions. "However, if all the additional revenue was raised from this group this could aggravate concerns over a ‘two-tier’ pension system with public sector workers being protected from tax rises," he says.
The former pensions minister adds: "As a result, the chancellor may ditch more radical ideas such as applying ‘flat rate’ tax relief on pension contributions, and instead try to find other ways of cutting the tax breaks to those with the largest pensions.
"For example, the HMRC figures also show that the previous lifetime allowance (LTA) generated charges of £516 million for the government in 2022/23, before the LTA was abolished by Jeremy Hunt. The new chancellor may be very tempted by a figure of this magnitude to look for a way of reintroducing a lifetime limit of some sort."
Cutting tax relief could discourage pension saving
Apart from proving politically unpopular, another reason the government could be reluctant to tinker with the rules around pension tax relief is that doing so could make pension saving less attractive.
The government is on a mission to boost investment in UK markets and the economy, and sees pensions as an important vehicle for doing this. Retirement savings are one of the biggest sources of investment capital.
Current tax relief rules mean that pensions are an attractive option for savers. Pensions offer more generous tax incentives than ISAs, for example.
“Reducing the upfront incentive for people to save in a pension would run counter to wider government efforts to boost long-term investing and risk undermining the flagship automatic enrolment reforms,” says Selby.
“In addition, younger people who are less likely to have benefitted from higher-rate tax relief may feel understandably aggrieved that a benefit offered to the previous generation has been ripped away from them,” he adds.
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