Big bold ideas on pensions tax relief

It feels like every time we approach a Budget or a Spring or Autumn Statement, the pensions industry and media whips itself up in a frenzy over pensions tax relief.

The current favourite rumour – the introduction of a single rate of tax relief – is initially appealing, but would struggle to work in practice, especially with respect to defined benefit schemes. This probably makes it a non-starter. But that doesn’t prevent most commentators reaching for it.

So, the IFS’s latest thoughts on this area were like a breath of fresh air. It quickly dismissed the single rate idea, and instead put forward a package of other proposals to help shift the parameters of pensions tax relief to make it fairer.

True, there was an initial stumble when it proposes capping tax-free cash. This is one of the few parts of the retirement system the majority of people both understand and value. As such, any move to remove or cap the available tax-free cash would risk undermining the fragile savings culture being built under automatic enrolment. It would also be deeply unpopular – a key factor given a general election is drawing near.

However, other proposals are worthy of further thought.

There are inconsistencies when it comes to how Income Tax and National Insurance Contribution (NIC) relief are treated under pensions. The IFS suggests that individuals’ contributions should receive up-front NIC relief, but instead pension withdrawals should be subject to NIC. Although this makes more sense – NICs are just a different form of tax – it’s hard to imagine this won’t spark fury among older voters. It would need a transition period; it would be unfair for those not receiving relief upfront to also be taxed on the way out.

Employer pension contributions receive NIC relief. But the smaller employer would not pay NICs anyway. So the IFS proposes applying NICs to all employer pension contributions but instead introducing a new subsidy on all employer pension contributions. The problem with that is if it comes in at a lower rate than NIC relief.

The IFS would like to scrap Income-Tax-free benefits on deaths before age 75 and bring pensions into the scope of Inheritance Tax (IHT). There is no doubt pension death benefits are very generous, however, this could be a politically bitter pill to swallow. IHT is one tax people dread paying (although relatively few are charged). An alternative may be to keep the IHT shelter, but apply Income Tax on pension withdrawals, perhaps after state pension age.

Most interestingly, the IFS propose the lifetime allowance should only apply to defined benefit members, and instead defined contribution members should have a lifetime contribution cap. Whereas a lifetime cap sounds tricky to apply in practice, I agree with the principle of only limiting contributions for DC members. That would be much fairer, and not penalise DC members for good investment. The IFS’s proposal to simplify the system by removing the tapered annual allowance is also appealing, although I would go one step further and also get rid of the MPAA.

In practice though, this division may be difficult to achieve. There are some big stumbling blocks in how to treat those going from DB to DC membership, or vice versa, to stop them gaming the system.

Although I don’t agree with all the details of the proposals, I admire the IFS for its thorough review of the issues. Pensions need simplifying and more fairness introduced into their rules. We need less rhetoric, and instead more bodies putting forward big bold ideas like these.