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Pension tax relief cuts will hit payslip pitfall
Even those expected to benefit from a flat rate of pension tax relief may be put off the measures.
by Michelle McGagh on Jan 28, 2016 at 11:05
A flat rate of pension tax relief could disincentivise workers from savings as employer contributions will have to be taxed and the relief then clawed back.
The Treasury is currently consulting on reforms to the way tax relief is provided on pension schemes in order to incentivise more people to save. The consultation proposes either keeping the system that is currently in place, changing the rates of relief currently on offer, or taxing pensions in a similar way to ISAs.
Most experts are expecting the Treasury to introduce a flat rate of tax relief. At the moment tax relief is paid at the highest marginal rate of income tax paid, meaning those who earn more get more relief. Around 75% of tax relief goes to higher earners.
A person paying basic rate tax of 20% has to put 80p into a pension in order to save £1 while a higher rate taxpayer paying 40% has to contribute just 60p to save £1.
A flat rate of tax relief is likely to be below 40% and most discussions have centred around relief at 25%, 30% or 33% - meaning those paying 20% income tax will receive more of a boost on their pension savings.
There are concerns about the way a flat rate would be administered and the Pensions and Lifetime Savings Association (PLSA) has warned that the complexity with offering a flat rate of relief could act as a barrier to saving for workers, rather than incentivise it.
Relief comes later
Currently, employers pay pension contributions gross, meaning they do not get hit with any tax. However, under the new system – because the rate of relief would no longer correspond with marginal income tax rates – employers would have to pay contributions that had been taxed and then the relief clawed back later.
Jackie Wells of the PLSA said although there had been no formal indication of how a flat rate would work, discussions she has been involved in point to that as the most likely outcome.
‘The way it is today is that the employer contribution does not go through payroll at all, it is paid gross but under a flat rate the employer contribution will appear on payroll and added to income and made subject to your marginal rate of income tax,’ she said.
‘For a basic rate taxpayer this would mean 80% [of the employer contribution] would go to the scheme and then the scheme would reclaim the single rate.’
Although the basic rate taxpayer would not be missing out once the tax has been reclaimed by their employer, the employer contribution figure shown on their pension statement would be lower.
Wells added that those who were on the cusp of paying higher rate income tax could find they were pushed over into 40% tax as their employer contribution was added to their income.
‘If they are nudging the 40% rate, if you add employer contributions [to their income] some people could get taxed at higher rate because it trips them into that band,’ she said.
Basic rate taxpayers would not lose out from a flat rate of relief, as it is likely to be higher than 20%, but Wells said the changes would do little to incentivise people if they see their employer contribution reduced at the start.
‘Of course, it depends on whether people look at their pay slips and some will and you can be sure the unions will be,’ she said.
‘There is no point in incentivising people with an increase in tax relief if they do not see the incentive. What they will see on their payslip is a tax on the pension contribution where there wouldn’t have been before…it is possible that people will think that is not worth [saving].’
While basic rate taxpayers may feel like they were losing out on pension contributions, Wells said for higher rate taxpayers definitely there was no question they would be worse off.
‘If you are a higher earner 40% tax will come off your employer contribution and then the scheme will get back the flat rate, say 25%, so you have paid 15% tax on the pension contribution and when the [pension savings] come out in future you will be taxed again at a marginal rate,’ said Wells.
Claire Trott, pension expert at Talbot and Muir, said the change in the way tax relief is given to workers could have a ‘psychological affect’ as people will feel they their employer contributions were no longer as generous.
‘If you have a flat rate the employers will have to treat [their contributions] as earned income – that could change the way everyone contributes,’ she said.
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