Rumours are growing that in the spring Budget on 16 March George Osborne will scrap the higher-rate tax relief available on pension contributions and replace it will a flat rate.
That would mean all taxpayers getting the same level of tax relief however much they earn. Some might say that sounds fair, but while it would benefit the estimated 15 million workers who pay into a pension scheme, the 4.9 million people who pay higher rate tax would be hit.
What might the change be? At present you earn tax relief on your pension contributions at your normal tax rate. So for the majority that’s 20 per cent, but for those who earn more than £42,835 a year it’s 40 per cent, while top rate taxpayers earning £150,000 or more get 45 per cent tax relief.
To put it another way, for every £1 that goes into your pension pot you only need to put in 80p if you’re a basic rate taxpayer because of the government top up. If you’re a higher rate taxpayer, you only need to put in 60p to get a £1 in your pension, while highest-rate taxpayers only need to put in 55p.
Under the expected changes, a flat rate would be introduced. There’s been little indication of what it might be but expects reckon it could be 25 per cent or 33 per cent.
“It would have to be higher than basic rate and lower than higher rate,” said Tom McPhail, head of retirement policy at Hargreaves Lansdown. “We recommended 33 per cent, in other words, for every £2 you pay into a pension, the government would pay in £1.”
If it was set at 25 per cent, it would mean for every £3 you pay in, the government would top it up by £1.
As our figures below show, a 33 per cent flat rate would benefit the pension payout of a typical basic rate taxpayer by £1,080 but leave a typical higher rate taxpayer £980 a year worse off.
A 25 per cent flat rate would only give the basic rate taxpayer an extra £370 a year, but hit the higher rate taxpayer to the tune of £1,880 a year.
The fact that millions more are likely to benefit than lose out explains why 60 per cent of the population would be in favour of a move to a flat rate if it was set at 33 per cent, according to research from Aegon.
"Assuming the single rate is set somewhere between 25 per cent and 33 per cent, it would mean pensions become more attractive to low and modest earners as the Government would be giving a bigger boost every time a basic rate or non-taxpayer pays into their pension," pointed out Steven Cameron, regulatory strategy director at Aegon.
However, the more you contribute to your pension, the more you will gain or be hit. It means middle class savers need to act now before George Osborne introduces the flat-rate, warned Nigel Green, boss of the deVere Group. “Millions of people, who currently receive between 40 and 45 per cent relief, could see a significant drop in their retirement funds so the time for higher earners to act is now. Take the tax relief while it lasts," he said.
Tom McPhail agreed. "Logically, if the Treasury is going to announce a flat rate system for the future, they’d have to bring down the shutters on 16 March, in order to prevent wealthy investors from grabbing any last share of the higher rate relief before it is abolished."
If they didn’t do this, he estimates it could cost the government an extra £6bn within a few weeks.
"Any higher earners who are looking at paying into a pension, should think seriously about doing so before 16 March," he advised. "Conversely, for basic rate taxpayers, it may make sense to wait until after that date."
Q&A: What is the single rate likely to be and when will we find out?
That’s the big question. Suggestions are it could be between 25 per cent and 33 per cent. The higher the rate, the more help the Government will be giving pension savers, but it will also cost them more money as they’ll collect less income tax. The Chancellor may not announce the rate in this year’s Budget – he may leave that till his Autumn Statement or even later.
Will it make pensions simpler to understand?
Research shows that many people do not understand the way pension tax relief works. In simple terms if you pay in £100, the Government will add a further amount. If the single rate is 33 per cent, you’d get an extra £50 from the Government. If set at 25 per cent, you’d get an extra £33. At the moment, a basic rate taxpayer gets an extra £25 for every £100 they contribute.
How will contributions from employers be treated?
That's one of the more complicated decisions the Chancellor will be grappling with. It’s important that employers continue to get tax breaks if they contribute to their employees’ pensions. But there are likely to be changes to the system as otherwise, there are ways for higher earners to get more relief by agreeing with their employer to swap some salary for a higher employer pension contribution.
How a flat rate pension may affect you
Typical basic rate taxpayer (aged 30 putting £80 a month into their pension, retiring at age 68)
Under the current system with 20% tax relief: pension pot £107,000: projected annual pension income £5,580
If the flat rate was 25%: pension pot £114,000: projected annual pension income £5,950
£370 a year better off
If the flat rate was 33%: pension pot £128,000: projected annual pension income £6,660
£1,080 a year better off
Typical higher rate taxpayer (aged 40 putting £500 a month into their pension, retiring at 67)
Under the current system with 40% tax relief: pension pot £180,000: projected annual pension income £9,420
If the flat rate was 25%: pension pot £144,000: projected annual pension income £7,540
£1,880 a year worse off
If the flat rate was 33%: pension pot £161,000: projected annual pension income £8,440
£980 a year worse off
Source: Hargreaves Lansdown