Financial futures: budget pension changes part two?

At the moment pension savers generally get tax relief at the rate which they pay income tax – 20, 40 and 45 per cent – and only pay tax when they withdraw money.

However, with people living longer and the changing nature of pension provision, the government announced that it wants to incentivise more people to take responsibility for their pension savings so that they are able to meet their aspirations in retirement, and opened a consultation on reforming the pension tax relief system.

It is set to reveal the outcome of its consultation on pension tax relief, ‘strengthening the incentive to save’, in the Budget on 16 March.

One change speculated is to turn the current system on its head and introduce a so called Pension Isa (also known as a Taxed-Exempt-Exempt or TEE system).

Pension ISA
This would mean pension contributions would be paid from income after tax, with no tax relief on contributions; but there would then be no tax charge on pension withdrawals when taken in retirement.

Without the incentive of early tax relief on contributions, there is the risk that some may be put off saving into their pension, undoing the positive impact that auto-enrolment has had.

Ben Gaukrodger at the Association of British Insurers explains why he believes a Pensions Isa would be a mistake.

Another possible downside is that pension savers’ future pension pots are likely to be reduced: without tax relief at the point of saving, contribution levels will be lower and therefore the pension pot will ultimately be smaller.

However, a major benefit of the Pension Isa is that 100 per cent of the pension fund would be tax-free on withdrawal, instead of only 25 per cent – resulting in a huge tax saving in retirement when perhaps the income is needed the most.

Introducing a Pension Isa would be a big call for the chancellor though, as it would be a radical change to the system, bringing dramatic implications for employers, scheme managers and trustees, as well as employees.

A perhaps less radical option is for pension withdrawals to be left alone, but with changes made to the rate and way tax relief is given, possibly including even further reductions to the annual and lifetime allowances.

As it stands, from April this year individuals with income of over £150,000 will generally see a reduction in their annual allowance from the present £40,000 limit. For every £2 earned above £150,000, their annual allowance will fall by £1.

Therefore someone earning £210,000 will only be able to contribute £10,000 each year into their pension. The lifetime allowance is also reducing from its present £1.25 million to £1 million from April.

Flat-rate tax relief
Many are predicting a move to a flat-rate plan that would see all individual pension savers given tax relief at the same rate – likely to be set between 20 and 33 per cent regardless of whether they pay basic, higher or additional tax.

A flat rate system could make pensions a significantly less attractive place for higher rate earners to save for their retirement. However, remember that other features may still be attractive, such as a 25 per cent tax-free lump sum and inheritance tax benefits.

The flat rate plan could also do more to encourage basic rate taxpayers to save into a pension. For example if a flat rate of 33 per cent were introduced, those that pay income tax at rates lower than this would really benefit. The idea is that more of the tax relief would be directed to people on a lower income.

Whatever is announced in the Budget, I believe that the best approach is for individuals to have a well thought-out retirement plan, which considers all forms of retirement income and not just pensions.

Those with alternative forms of retirement income may be able to use careful tax planning to phase their withdrawals and ensure they don’t pay unnecessary tax on their pension income.

Some people will prefer to manage this themselves, which could be fine if they know what they are doing and what options are best for them, but the value of fully regulated advice should not be underestimated and can more than pay for itself.