Govt urged to 'even out' pension tax support

The government has been urged to 'even out' tax support for pension saving, after research from the Institute for Fiscal Studies (IFS) suggested that the current tax system is not doing enough to support those facing low income in retirement.

The report, which was funded by Abrdn Financial Fairness Trust, argued that current approach to pension tax relief does "nothing" to support low earners, adds significant complexity and leaves subsidies that are still too generous for some.

In light of this, it argued that a long-term vision for the system is needed, outlining a number of specific proposals designed to 'even out' tax relief for pension saving and reduce overly generous subsidies.

Indeed, the IFS estimated that the proposed reforms would also boost the retirement incomes of the bottom 80 per cent of earners and provide greater encouragement for them to save more in a pension.

In particular, the report called on the government to reform the 25 per cent tax-free component to provide a more equal subsidy to all private pensions, benefiting those with a low retirement income.

Although the IFS acknowledged the popularity of the current arrangement of allowing savers to take a quarter of their pension free of income tax, it argued that this is of "no value at all" to those with the lowest incomes in retirement, non-taxpayers, instead providing a large tax subsidy to those with high incomes and big pensions.

It therefore argued that the tax-free component should be capped so that it only applies to 25 per cent of, for example, the first £400,000 of accumulated pension wealth, estimating that this would still leave about four-in-five of those approaching retirement unaffected.

However, it also outlined more advanced proposals to replace the tax-free component with a new subsidy, explaining that this could be designed to be as generous as the existing system to basic-rate taxpayers but to provide equivalent support to non-taxpayers.

More broadly, the report recommended giving up-front employee national insurance contribution (NIC) relief on all pension contributions, and tax pension income instead, arguing that this would align the income tax and employee NICs systems.

Alongside this, it recommended decoupling the up-front tax subsidy from employer NICs, arguing that the "huge tax break" on employer pension contributions is "of no value when employers are not liable for employer NICs – for example, small employers".

Given this, it recommended applying employer NICs to employer pension contributions, suggesting that a new subsidy on all employer pension contributions could then be introduced.

Echoing previous industry calls for action, the report also called for reform to the lifetime allowance and the end of the tapering of the annual allowance, arguing that these allowances have created complexity and "damaging disincentives" for an increasing number of higher earners.

The IFS also argued that as the other reforms proposed would get rid of the excessive generosity in the current system, they would allow policymakers to be more relaxed about these aforementioned limits.

Whilst cost has often been seen as a barrier to tax reform, the report argued that the reforms could be made revenue-neutral in the long-run, and even in the short run, explaining that while there would be an up-front cost to giving relief on employee NICs, this could readily be met by reducing the generous treatment of employer contributions.

It also suggested that further revenue could be raised by applying some NICs to pension withdrawals immediately, stating that there is an argument for such a levy given that those with high levels of private pension income will almost all have enjoyed significant employer contributions on which no NICs were ever paid.

IFS research economist and author of the report, Isaac Delestre, stated: "Pension saving is treated generously for high earners. Even under pension caps, over £250,000 can be withdrawn from a pension free of income tax.

‘Our proposals would boost the retirement incomes of low and middle earners and provide greater encouragement for them to save more in a pension.

"They provide a coherent vision for the taxation of pensions and don’t require the complexity, and big losses for some current basic-rate taxpayers, that would result from restricting income tax relief to the basic rate, for which some have argued.

"This evening-out of tax support for pension saving would be more equitable and more economically efficient, and would allow the current set of poorly designed limits on what individuals can save in a pension to be relaxed.

"We would retain the current system of up-front relief from income tax that is of much benefit to higher-rate taxpayers.

"Our system of pensions taxation has too many features that are arbitrary, wasteful or unfair. It’s long past time we retired them."

Adding to this, Abrdn Financial Fairness Trust chief executive, Mubin Haq, stated: “Collectively we save £115bn a year in workplace pensions, with these savings treated generously by income tax, National Insurance and inheritance tax.

"But many of these tax reliefs are more generous to those with the largest pension pots, whilst millions of those on low-to-middle incomes are likely to fall far short of the retirement savings they need to support them in old age.

"Today’s report proposes a set of recommendations which would rebalance where our tax reliefs go, with the bottom 80 per cent of earners gaining most from the reforms. This would help deliver greater financial fairness and boost retirement savings for those who need them most."

However, industry reaction to the proposals has been mixed, as although experts have agreed with the need for tax changes, concerns around the risk of unintended consequences are emerging, while others have identified further areas of consideration, such as the money purchase annual allowance.

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