A system to encourage basic-rate taxpayers to start savingby Craig Mackinlay / March 1, 2016 / Leave a comment
Read more: Imagine what we could do if we got pensions right
The last 20 years have seen tumultuous changes to pensions—state, public sector and private sector ones alike. Yet more reform is likely, in the area of tax relief. From my work as both a chartered accountant and chartered tax adviser, I know that our tax code is already too complicated, running to nearly 20,000 pages. It’s best to avoid complicating it further.
The tinkering started in 1997, when Gordon Brown stopped pension schemes from reclaiming tax credit on dividends. A 2006 paper for the Institute of Actuaries estimated that this move wiped £150bn from the value of retirement funds. It was the beginning of the end for private-sector final salary schemes, which companies now deem too costly.
Recent changes have affected higher-rate taxpayers more than others. Reductions since 2010 to the lifetime allowance (the amount you can accumulate in pension funds without incurring extra tax) and now the annual allowance (the amount that you can put each year and still get tax relief) may save the public purse billions of pounds but they have made the system more opaque and hard to understand. However, restrictions in last July’s Budget on contributions by those earning £150,000 and above are to be balanced by a relaxation of the inheritance tax rules on family homes.
All this flux has left those heading for retirement wondering what the best way to secure their future is. It’s unsurprising that some have stashed their money in ISAs or relied on buy-to-let property instead, especially as they can withdraw their capital at any time. But the 2015 Budget will discourage people from taking the last route by cracking down on mortgage interest tax relief and imposing a stamp duty surcharge on the purchase of buy-to-let properties.
Higher-rate taxpayers make pension contributions for tax relief, rather than income in retirement; they will draw on their other savings and investments in old age. Tax relief on pension contributions will most likely approach £35bn in the financial year 2015-16. That figure rises to £50bn a year when you factor in salary sacrifice arrangements and their impact on National Insurance Contributions (NIC). These sums could make a meaningful impact if applied to the budget deficit instead.
Basic rate taxpayers are the ones that need to put more into their pensions. The recent moves to auto-enrolment will help but with investment returns as low are they are, the proposed minimum statutory contributions alone won’t lead to a comfortable income for retirees. How can the Treasury encourage them to save more?
To simplify, pensions can be split into three stages: contributions (payments made by individuals and employers), investment (the payments go into a fund, which is invested) and benefits (individuals taking payments from the fund). The tax relief system on each stage can be described as Exempt Exempt Taxed (EET). That is, contributions get tax relief; most investment growth is exempt from taxes; payments to members are subject to income tax, after a tax-free lump sum payment.
One policy suggestion is a Taxed Exempt Exempt (TEE) system instead. Under this ISA-style system, contributions would not get tax relief but investment growth would, and so would eventual payments to members. The danger here is that a subsequent government could impose a tax on the third stage, turning the system into a TET one.
At present, those on higher incomes receive pension tax relief of 40-45 per cent, while others receive as little as 20 per cent. A flat rate of pension tax relief is a possibility. A similar kind of tax relief already exists with, for instance, the Enterprise Investment Schemes (EIS), under which investors buying shares in small high-risk companies can claim 30 per cent of the investment back as a tax refund under certain conditions. Using this as a guide, I propose a flat rate of tax relief of 30 per cent, while keeping existing top-up arrangements for basic-rate and non-taxpayers.
Tackling salary sacrifice will be harder if cumbersome anti-avoidance legislation is to be prevented. The problem lies in defining avoidance—would it include defined benefit schemes? What about employers reducing a salary increase on the grounds of their new contribution requirements? These might fall into the category of benefits in kind. Here I propose that salary sacrifice of up to £10,000 should not be recognised. There would some loss of tax and NIC but this would keep it simple and ensure that those behaving innocently do not run foul of benefit-in-kind anti-avoidance laws.
I also propose that the tax-free lump sum received by those cashing in their pensions should be capped at 25 per cent (as it is now) or £50,000, whichever is the smaller. Again, basic rate savers would not be out of pocket. Finally, the first £5,000 of income from pensions should be tax-free, up to the higher-rate threshold. The Treasury would deem this tranche of a pension to have been taxed at the source, in a similar way to single premium investment bonds.
The effects of these changes on behaviour would be to reduce large contributions by higher rate taxpayers and increase take-up among basic rate taxpayers. On my estimate, when you factor in the annual savings on tax relief that favour higher and additional rate taxpayers, public finances will be better off to the tune of £10bn a year.
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