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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

Pension tax relief cuts will hit payslip pitfall

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.

Invisible incentive

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.

28 comments so far. Why not have your say?


Jan 28, 2016 at 13:01

I see the article is using the Government's favourite argument: "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". This is utterly misleading, because you could put it another way and say that everyone has to earn £1 to be able to make a pension contribution of £1 no matter what rate of tax they pay, which seems completely fair to me.

Doing it any other way will be a nightmare for pension schemes, especially those using salary sacrifice.

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Jan 28, 2016 at 15:01

PaulSh is spot on - £1 earned is £1 earned. It seems to me that the flat rate system is designed to appease those who misperceive the higher rate tax relief as an unfair advantage given to those who earn more - aka those who pay more tax (but let's not worry about that little detail...).

To achieve the same effect of perceived equality, the existing system could be retained but the language changed to appear more equal - e.g. pension contributions are taxed at 0% regardless of how much you earn or which tax bracket you're in. There. That makes a top rate tax payer and a basic rate tax payer equal - each pay the same tax rate on pension contributions.

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Andrew May

Jan 28, 2016 at 15:43

Exactly so PaulSh and Tarrier.

The only way a 30% flat 'tax relief' on pension contributions is fair and reasonable is if there is a flat 30% income tax rate.

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Jan 28, 2016 at 15:52

In fairness, the not-so-cynical reason it's being considered is to encourage people to save - and I can see the incentive for someone paying 20% income tax to save with @ 30% tax relief (it's free money!). But anyone paying income tax at rate higher than the flat rate would effectively be dis-incentivised to carry on saving as much - and the same probably applies to employers who contribute - will these contributor schemes continue to operate as is? Or will these lead lower employer contributions?

I vote for simplicity (0% tax on pensions contributions across the board) - not only because it's the fair thing to do, but also because I also work in the Life and Pensions industry and cringe at the thought of the complications that would accompany any disparity between income tax rates and pension contributions tax rates.

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Law Man

Jan 28, 2016 at 16:07

Taking the problem of a difference between 33% relief and 20% income tax, is it not possible for computer systems to cope with this? Something like:

1. Pension co adds 25% to give an effective 20% tax relief, while

2. The employer system credits the balance?

Otherwise - and for where the employee is not in an employer pension scheme - I imagine it would have to be done through the Tax Code.

Note: This idea may have some flaw because systems cannot cope, or otherwise.

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Jan 28, 2016 at 16:11

Not saying it's not possible, Law Man - it just adds unnecessary complication.

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Jan 28, 2016 at 17:13

Currently, the tax relief on occupational pensions works by simply taking the pension contribution out of gross income rather than net, which automatically gives tax relief at the marginal rate. The alternative would be to operate it like a personal pension - taking contributions from net salary, the pension fund claiming basic rate relief from HMRC to be credited a few months later, and then the employee reclaiming any further relief (if the amount of relief is actually set at a higher rate than 20%) either via the annual tax return or perhaps via a tax code adjustment.

On a related matter, if they do introduce a "one size fits all" tax relief percentage, why not make it truly universal and abolish the distinction between earned and unearned income for pension contribution relief, at least for people below state pension age? This would be especially beneficial for couples where only one of them works as pension contributions could then be split 50/50 between them, rather than having to go mainly into the working partner's pension.

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Law Man

Jan 28, 2016 at 17:23

Paul Sh makes me think of the £3,600 limit for gross contributions to be eligible for 'tax relief' where the individual has no taxable income. This limit has not been raised for a very long time.

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Money Spider

Jan 28, 2016 at 17:43

Law Man - a salient point.

If the government's objective is to have a universal rate of pension tax relief (or 'deferred income tax' as I prefer to call it) then the non-earners should receive it too:

i.e. at 30% relief rate, the net cost to them should be £2,520, rather than the current £2,880 or, more fairly, given that this gross figure hasn't risen for a long time, the current gross limit of £3,600 should rise to £4,114 (equating to a net cost of £2,880 at 30% rate).

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Michael Wakefield

Jan 28, 2016 at 19:09

The elephant in the room is a state still too big and a tax base that cannot fund it. So like Gordon Brown they are looking to raid pension funds.Nothing to do with fairness. Still at least we haven't got to the point where the governments finances are so bad they have to nationalise peoples pensions.

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Michael Stevens

Jan 28, 2016 at 20:50

Let the employer pay gross and the member the flat rate. 20% pay £80 for £100.

Just like Group Personal Pensions as at present.

Keep it simple.

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geoffrey mulford

Jan 29, 2016 at 06:07

Paul sh

You are completely wrong. What you haven't considered is the fact that pensions are taxed on the way out. So a 40% tax payer gets 40% tax relief on the way in and pays 20% tax on the way out. giving him a 20% tax advantage.

A 20% tax payer gets 20% tax relief on the way in and pays 20% tax on the way out. There is no point in paying into a pension for 20% tax payers.

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Jan 29, 2016 at 07:35

As a skilled engineer of 53 they are going to tax me into early retirement, this means I will not be passing my knowledge onto the next generation.

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Tug Boat

Jan 29, 2016 at 09:02

Geoff, there is a point to having 20% tax relief, as this gives 20% more income generation from the investments.

Also, I was lucky enough to have 40% relief on the way in, I now have 0% on the way out.

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Jan 29, 2016 at 10:09

@geoffrey mulford, as long as your pension contributions do not exceed the annual limit, the whole of your contribution is eligible for tax relief. However, when you draw your pension, you will benefit from the personal tax allowance and so not all of it will be taxed. No matter how you work the tax relief under the current untaxed-untaxed-taxed system, there will generally be an advantage when you retire whether you are a higher rate taxpayer or not. And in any case, how someone decides to balance their income during their working life versus their retirement is their affair, and they have the perfect right to arrange things so as to obtain the maximum advantage from the system.

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geoffrey mulford

Jan 29, 2016 at 11:54


How much are we talking here?

Next years tax code is reported as being £11,000 state pension £8,000

That means a 20% tax payer could have a private pension of £3,000 a year before then losing all the benefit of tax relief Well whoopee doo.

I think you have to be a 20% tax payer to understand the unfairness.

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Dave Hill

Jan 29, 2016 at 14:27

Geoffrey you are assuming so much. A 20% taxpayer would be on a lower income so they probably would not pay any tax on the way out, so making 20%. How many lower earners would have a pension income of over £11000. Not many. Most of my pension contributions were at 40% and my income is £16000. Most of this is tax free, so I pay 20% on £5000.

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geoffrey mulford

Jan 29, 2016 at 16:17

tug boat. you are wrong.

lets compare a pension with an ISA with the investment doubling.

ISA £8,000 in doubles to £16,000

pension £8,000 in tax relief added £10,000 then it doubles to £20,000 take away 20% tax on the way out £16,000

The only way tax relief on pension benefits any one is if the relief on the way in is greater than the tax on the way out.

Dave hill why is your pension so low? State pension alone should be higher than that.

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geoffrey mulford

Jan 29, 2016 at 16:35

Sorry dave hill miss read your post.

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Jan 29, 2016 at 17:00


The problem with your "unfairness" claim is that paying any tax on pensions contributions that is not in line with the tax paid on the income is grossly unfair. Let's assume His Osborneness decides a flat rate of 30% of pensions contributions. If you pay income tax of 20% tax and I 40%, notwithstanding that I'm already paying more tax than you, you are actually going to get a boost as though you have earned 10% more than you actually did. You didn't earn that money, how could you claims it's fair that you are given it?

The simple truth, as per my OP, is that pensions contributions are tax free, both to encourage saving and to facilitate maximising the returns before the tax man gets his cut. Why you should get back more tax than you've paid - and claim that to be fair - baffles me.

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geoffrey mulford

Jan 29, 2016 at 17:33

Ok I would compare what the tax relief means in money terms for a 20% tax payer to a 40% tax payer.

assumptions state benefit £8,000 lower tax code £12,000 upper tax at £50,000

The private pension of the 20% tax payer is higher than £4000 he gets £800 a year in tax benefit.

The private pension of the 40% tax payer is higher than £42,000 he gets £1,600 tax benefit for the first £4,000 £7,600 for the next £38,000. so a total of £9,200 compared to £800

Is my maths right?

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Jan 29, 2016 at 17:52

Just play your points back in reverse - that is, when income is drawn and tax is paid - and you should easily realise why your case holds no water... unless you're keen on a flat rate of income tax, too.

Basically you're saying that my £1 earned is worth less that your £1 earned, and that this should be reflected when we save into pensions.

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Tug Boat

Jan 29, 2016 at 18:18

Not prepared to argue, you win Geoff.

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Tug Boat

Jan 29, 2016 at 18:25

Remember The eighth wonder of the world, paraphrasing an old guy but...

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geoffrey mulford

Jan 29, 2016 at 22:30

Well no one has argued with my maths yet. and Osborne is looking at changing it so I must be right.

One thing I have learned in life is that it is very difficult to spot your own vested interest. My guess would be that most 20% tax payers would agree with me and most 40% disagree.

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geoffrey mulford

Jan 30, 2016 at 00:15

Tarrier have a quick look at this

This shows that the 20% tax thing is a myth. The only people that pay 20% tax are pensioners real tax rates are 32% and 42%

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Dennis .

Jan 31, 2016 at 14:14

I can remember in the 80's when tax rates went up to 60% and I was faced with what to do with my first £10k bonus. The thought of only getting £4k in my hand meant that it went straight into my AVC account alongside my pension. In those days it was a no brainer for anyone who was a high earner.

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mark antrobus

Feb 02, 2016 at 02:04

Going back to the original article - the law of unintended consequences.

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