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Setting the scene for tax relief changes?

3 weeks ago

As far as personal finance went, last month’s Budget was a quiet one. The bad news of a temporary increase to National Insurance contributions and creation of the new Health and Social Care Levy had been announced the month before, leaving the Budget free to be full of good news – from universal credit reform through to a reduction in the duty on Prosecco.

Another piece of good news was that, over a year since the consultation had closed, HMRC had finally decided how to award very low earners paying into a pension the same amount of tax relief regardless of the type of scheme they use.

The net pay anomaly

The Treasury was trying to solve the net pay anomaly. A very low earner paying into a pension scheme that operates relief at source (RAS) will receive 20% tax relief on all their contributions (as long as the gross contribution doesn’t exceed £3,600 or 100% of their earnings if higher). This is regardless of how much actual tax they have paid.

However, under a net pay pension scheme, a lower earner only receives tax relief up to the amount they would have paid as tax because their contributions are taken from salary before tax is calculated.

Put simply, if someone earning below their personal tax allowance pays a pension contribution of £100 into an RAS scheme, they will have £125 in their pension pot, but the equivalent person paying into the net relief scheme will have £100. That’s unfair. And as the person will have been automatically enrolled into a net pay scheme chosen by their employer, they have no power to change the scheme. And probably no knowledge they are losing out on a bigger pension pot.

The solution

The Treasury’s solution is to build a system to make top-up payments directly to low-earning individuals saving in a pension scheme using a net pay arrangement, with the intention to better align outcomes with equivalent savers saving into RAS pension schemes.

The Government will identify who qualifies and notify them direct that they are eligible for a top-up. Individuals will have to supply details to HMRC (presumably about their earnings). The Government will then make the payment directly to the individual, and not to the pension scheme. So, in the example above, the person paying into a net pay scheme will still have a pension pot worth £100; it’s just they will have £25 in their purse as well.

Too little too late?

The Treasury reckons this solution will benefit 1.2 million individuals – 75% of whom are women – and that the average payment will be £53 a year. But will it work in practice? The money isn’t paid automatically; individuals have to claim it when HMRC gets in touch. That’s a daunting process for most people, especially if they have to supply information. Sometimes there is a reluctance to share everything with the authorities.

The Treasury is probably working on the basis that not everyone will claim. As a very rough calculation, 1.2 million people claiming £53 each adds up to a cost of £64 million. But in the Budget costings, the Treasury has only allowed for a cost of £10 million in the first year of operation and £15 million in the second.

This solution is not going live any time soon. The first payments will be made in respect of the 2024/25 tax year but won’t be paid out until the end of the 2025/26 tax year. Those who have been automatically enrolled since 2012 will have to wait another four and a half years before they can start to see any benefit, and no recompense is being offered for contributions made in those earlier years. It also won’t boost their pension pot. They will get cash. For many, that will be more appealing than the money being tied up in a plan they can’t get hold of for many years. But it does mean, when they get to sorting out a retirement income, they will have a smaller pot and will have lost out on years of compound growth. And after all, tax relief is given to encourage pension saving.

Setting the scene for other tax relief changes?

This is a big change for HMRC requiring a serious system build. But it does create an interesting situation. It gives HMRC a way of getting in touch with people to say it owes them tax relief; and by a natural extension, it could also give it a way of getting in touch with people to get them to repay tax relief.

The idea of flat rate pensions tax relief is one that is often bandied around. But a quick glance at the subject misses the point that to put it into practice would be fiendishly difficult. Creating a new tax relief system is one way some problems could be alleviated and may pave the way for the flat rate solution to get proper consideration.

This article was previously published by Professional Adviser.

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Rachel Vahey
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Rachel Vahey

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Senior Technical Consultant

Rachel is a Senior Technical Consultant helping financial advisers and planners understand the changing pensions and savings environment, as well as how new legislation and regulation affects them and their clients. She’s well known within the pensions and savings industry, and regularly speaks at AJ Bell events, alongside writing content and articles for our website.

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