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Potential Changes to Pension Contributions and Taxation

Billy-Patrick Conkie

Significant changes to pension taxation may be on the horizon, given the government's plan to raise taxes to address the recently reported £22 billion budget deficit. 


The government could potentially adjust pension taxation in several key areas: 


  • Tax Relief and Contribution Limits 

  • Taxation Within Pension Funds 

  • Taxation on Withdrawal of Pension Benefits 

  • Taxation on Pension Benefits After Death 


It is unlikely that the government will change the tax-exempt status of investment growth within pension funds (i.e., taxation on dividends, savings, and capital gains within the fund). Therefore, this analysis will focus on the remaining three areas where changes might be more feasible. 


Implementing these changes mid-year is uncommon, as it would create complexities for payroll systems and taxpayers' financial planning alike. 


Taxation on Contributions 


  • Limiting Tax Relief: One potential change could be reducing tax relief to a flat rate of 30%, rather than the current maximum rate of 45%. This would decrease your overall tax relief but would pay a smaller net amount into the pension as well smaller net amount for the adjusted net income amount to claw back the personal allowance.  However, implementing this before the new tax year is improbable due to the complexity of payroll adjustments, making it a significant administrative challenge. The complexities are even

    more stark for defined benefits pension.  


  • Lowering Contribution Allowances: The government could reduce the maximum allowable pension contributions, either by lowering the tapered annual allowance threshold or reducing the overall annual allowance. This would effectively reverse recent increases in these allowances. Such a change could deter high earners from saving for retirement, and special provisions for defined benefit pensions—such as those for doctors—might be politically challenging to implement. 


  • National Insurance Contributions (NICs) on Employer Contributions: The government could introduce NICs on employer pension contributions. A former pensions minister has suggested this may be the only change to pensions; however, this would not impact your personal contributions. 


Taxation on Pension Benefits 


  • NICs on Withdrawals: Introducing NICs on pension benefit withdrawals could align them more closely with regular income taxation. However, increasing taxes on withdrawals could be unpopular, especially given recent public sentiment around cuts to benefits like the winter fuel allowance. 


  • Reducing Tax-Free Cash Allowances: The government might reduce the tax-free cash percentage from 25% to 20%. Though possible, this would be a tough political sell. Alternatively, they could lower the tax-free cash cap from £268,275 to £200,000 or less. This approach may be more politically feasible, as it would affect only a small portion of the population. 


  • Reinstating the Lifetime Allowance (LTA): Although recently abolished, the Lifetime Allowance could be reinstated. They have recently committed to abolishing the LTA. Bringing back the LTA would cause problems mostly for doctors.  


Taxation on Pension Benefits After Death 


  • Uniform Taxation of Death Benefits: Currently, if an individual passes away before age 75, their beneficiaries can inherit the pension pot tax-free up to the lump sum and death benefit allowance of £1,073,100. The government could remove the age distinction and make death benefits uniformly taxable at the beneficiaries' marginal tax rate—similar to the tax treatment after age 75. Since many people are unaware of the current age distinction, this could be an easier adjustment for the government to make. 


  • Introducing a One-Time Tax Charge on Death: The government could impose a one-time tax charge on death, such as a percentage of the pension funds. Although not frequently discussed, this change could be appealing as public awareness of pension death benefits is low. 


  • Including Pension Funds in Estates for Inheritance Tax (IHT): Currently, pensions are excluded from an individual’s estate for IHT purposes. Including pensions within the taxable estate would have significant political implications, as it would dramatically increase tax liabilities for many families. 


Comments 


The primary goals for the government are threefold: to encourage more people to save for retirement, to tap into unused sources to grow the economy, and to raise several billion pounds to cover the budget deficit. This means that proposals encouraging lower-paid individuals to contribute to pensions, while promoting the withdrawal and spending of larger pension pots, would be optimal. A flat rate of 30% would increase basic earners pension pots and would reduce the overall relief on pensions as most of it is given to higher and additional rate taxpayers.


This policy along with taxing a pension pot over a certain amount would help their goals. What is optimal and what happens with changes is usually two different things.  


Although it could be possible, midyear changes would be an administrative nightmare for HMRC and payroll operators. A flat rate for contributions would be hard to introduce at any stage. George Osborne previously attempted to implement this change but was unsuccessful.  


Some changes would be more challenging politically, such as NICs on withdrawals, reducing the tax-free cash percentage and including pension within estates for IHT.  


They want to keep high earning civil servants and NHS staff onside, so some policies such as the annual allowance and reinstating the LTA would be difficult, unless they ringfenced defined benefit pensions. This would also reverse the recent changes which have increased pension contribution allowances and the abolition of the LTA. Changing the tax relief on contributions would also create huge complications for defined benefit pension schemes.  


The simplest way to raise taxes discreetly would be to change death taxation, particularly by applying a uniform approach for beneficiaries. 

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