GUEST COMMENT: Sorting out the tax anomaly

Written by Royal London director of policy Steve Webb
23/06/2016

Hundreds of thousands of low-paid workers look set to miss out on a vital part of their pension unless action is taken to address a growing anomaly in the way pension tax relief is delivered to members of some DC pension schemes.

Currently, there are two quite different ways of delivering tax relief to members of workplace pension schemes. One is called the ‘Net Pay Arrangement’ (NPA) where pension contributions are deducted from pre-tax pay before being paid into a pension scheme. This system works well for higher rate taxpayers because they get their full higher rate relief straight in to their pension pot without the need for any separate claim. This is the method generally used for defined benefit schemes and some workplace DC schemes.

The alternative method is known as ‘Relief at Source’ (RAS) where individuals make net pension contributions from their take-home pay and basic rate relief is delivered by direct payment from HM Revenue and Customs to the pension scheme. Higher rate relief then has to be claimed by higher earners, usually through their annual tax return.

In most cases, these two systems will produce the same result. But for low earners, the ‘Net Pay’ approach may give them no tax relief – for example, if they earn below the tax threshold – whilst the Relief at Source approach provides basic rate relief to all members, regardless of their tax-payer status. With a net contribution of £80 turning into £100 when basic rate relief is added under the RAS scheme, this means that pots will be one quarter larger if tax relief is delivered through this route rather than the NPA route.

The practical importance of this arises from the divergence between the threshold for paying income tax and the threshold trigger for automatic enrolment. Since April 2015, the trigger for automatic enrolment has been held at £10,000 per year. But the threshold for income tax is already £11,000 and is set to rise to £12,500 by the end of this Parliament. This means that hundreds of thousands of workers who earn between £10,000 and £12,500 will be automatically enrolled non-taxpayers. They will get no tax relief under the NPA arrangement but basic rate relief under the RAS approach.

It had been hoped that the big review of pension tax relief which concluded in the 2016 Budget might have resolved this issue once and for all, perhaps by moving all DC schemes over to the RAS arrangement. But nothing has been done and the government is now suggesting that it might be looked at in the 2017 review of automatic enrolment. Yet in the meantime, many workers will be losing out on valuable tax relief.

The government hopes that small employers will somehow get their heads round this and make sure workers are enrolled into RAS schemes where they are guaranteed to get tax relief. But this is a lot to ask of firms who are already struggling with the practicalities of automatic enrolment. The government should not leave this matter to a 2017 review, but needs to sort it out now.

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