New thinking on pension tax relief

The Institute for Fiscal Studies (IFS) has been spending a lot of time recently looking at pensions. Before Christmas we had a paper on tax treatment of pensions on death, and now they have followed this up with their blueprint for a better tax treatment of pensions.

The IFS are not shy of making big proposals that would shake up the pension world. Amongst other suggestions their previous paper recommended pensions are included within the estate for IHT purposes.

The premise this time is that too much tax relief goes to those that don’t need it. Under the current system of getting tax relief at the rate you pay it the wealthy gain the most. For many years now the concept of flat rate relief has been touted to address this issue. However, this is problematic when it comes to defined benefit schemes and employer contributions.

Instead the IFS have a new proposal – that personal contributions should benefit not just from Income Tax relief, but also National Insurance (NI) relief at employee rates. Following last year’s changes to NI thresholds the upper earnings limit matches the higher rate threshold (as long as you’re not in Scotland). So those who are basic rate taxpayers would get an extra 12% relief, whereas those that are higher earners would only gain an additional 2%. The flip side of this is that when taking pension income, NI would be payable. The idea here is that lower earners will benefit from more tax relief upfront – and have the benefit of tax-free compounding. High earners will benefit less as not only will they get less relief upfront, but they are also more likely to be taking pension income above the primary threshold to end up paying NI at 12.8% on the way out.

There are also changes proposed to employer contributions, to make NI payable in the same way that it is on salary. This would be replaced with a subsidy for employers at a set percentage which would apply to all employees – including those whom the employer currently does not have to pay NI for. The idea is to de-couple this from NI rates so the incentive for employers would not be tied to potentially fluctuating rates (as we had last year).

There are other changes in the paper that I’ll save for another day – but it is refreshing to see some different thinking in terms of pensions tax relief and a more workable alternative to the flat rate relief proposal.