Will Chancellor see pensions as means to help fill UK finances ‘black hole’?

29 July 2024

Chancellor Rachel Reeves has declared a ‘black hole’ in the nation’s finances. One of the big questions ahead of the confirmed Budget date of 30 October, Steven Cameron, Pensions Director at Aegon, says, is whether the government will opt for a radical reform of pension tax relief as part of the solution to fill the financial hole.

Following Chancellor Rachel Reeves setting out the scale of the gap in UK’s finances, Treasury civil servants have no doubt been dusting off their analysis of how reforming pensions tax relief might increase tax receipts.  

One of the plans to move to a flat rate of pensions tax relief somewhere between the basic and higher rates of income tax, which could be argued as fair, but also has its flaws. 

A flat rate of relief of say 30% would be good news for basic rate taxpayers. Currently, every personal contribution of £80 they make receives a £20 tax relief top-up. Under a 30% rate of relief, this would be increased to £34.28 – an extra £14.28 – which over time and with compound investment growth will provide a more generous pot at retirement. 

But this would be at the expense of higher and additional rate taxpayers who would get a less generous top-up. A higher rate taxpayer paying in £80 would also see this topped up by £34.28, less generous than the current top-up of £53.33.  

Higher rate taxpayers could face a double whammy as it’s likely they’d also be required to pay income tax on employer pension contributions. This would be needed to stop employees ‘doing a deal’ with their employer to sacrifice some of their salary in return for a higher employer pension contribution. This could mean employees paying tax of 10% of employer contributions, a further £10 hit for every £100 paid by their employer. 

In some schemes, employers pay very substantial contributions. In some public sector defined benefit pensions, employer contributions can be worth 20% or more of pay. Here, an individual earning £60,000 might be benefitting from an employer contribution of £12,000 a year and could be landed with a tax bill of £1,200. We’ve already seen the pensions tax system discouraging higher paid professionals in the NHS from remaining in work, and this could have a similar effect. 

A big unknown is how individuals will react to such a change. While basic rate taxpayers ae likely to continue as is, some higher and additional rate taxpayers might see pensions as less attractive. Faced with paying tax on employer contributions, some could even leave their schemes entirely, storing up real challenges for the future. So the change could be ‘friend’ to some but ‘foe’ for others. 

The decision comes while government is keen to encourage defined contribution pensions, with their billions in funds, to invest more in UK growth companies to support the growth agenda. But saving on tax relief means less money going into pensions, and this could be made worse depending on how higher paid individuals reacted. 

It’s right that a new Chancellor explores all options around taxation and tax reliefs. When it comes to pensions tax relief, it’s a careful balancing act between ‘fair or flawed’ or between ‘friend and foe.’   

 Main image: marcin-nowak-iXqTqC-f6jI-unsplash

Professional Paraplanner