Tax raid could cut your pension by £3,000 a year

by Ed Bowsher on 24 February 2012  |  13 comments
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The abolition of higher rate tax relief for pensions looks increasingly likely. It won't hit super-rich bankers; it's the 'squeezed middle' who will suffer.

I’m worried that the Government will cut income tax relief on pensions in the next Budget. It will hurt people who don’t regard themselves as wealthy and it will also discourage folk from saving for their retirement.

Let’s look at how the system works at the moment. Imagine you’re a higher rate taxpayer earning £50,000 a year. You save £4,000 from your post tax-salary into a pension pot, and you’ll then use that pot to give you an income when you retire.

As things stand, the Government gives you full tax relief on that £4,000 contribution, and so pays an extra £2,666 into your pension pot. In other words, for every 60p saved in a pension by a higher-rate taxpayer, the Government contributes 40p in tax relief to make it up to £1.

If you’re a basic rate taxpayer, the Government only contributes 20p in tax relief to your pension pot.

Now you might think that’s unfair. Why should people who earn more get more tax relief? Shouldn’t everyone only get 20%?

That’s certainly the view of Lib Dem Treasury minister, Danny Alexander. Abolishing higher rate relief would raise £7 billion that could then be used to fund tax cuts at the lower end of the earnings scale.

Bad idea

That sounds appealing when you first hear it, but I’m against this proposal.

My first reason is that there have been enough rule changes already. If you want to encourage people to save for their old age, they need to be clear what the rules are. If pension law keeps changing every two or three years, trust is eroded away. No one can be sure what the Government might do to their pension in future, and this uncertainty adds an unnecessary risk to pension saving.

Secondly, pensions are no longer a massive tax avoidance opportunity for the super-rich. Several regulatory changes in recent years have closed this loophole. The most important change was that people who earn more than £150,000 a year no longer get higher rate tax relief.

So if higher rate relief is now abolished, it won’t affect rich bankers, but it will affect people who earn as little as £43,000 a year.

A lot of people could be affected by this. The Institute of Fiscal Studies reckons that one in four people could be paying 40% tax by 2015.

Fidelity has done some calculations which show how damaging this change could be. Someone who pays £4,000 a year into a pension pot over 20 years could lose out on tax relief worth £56,000. At today’s rates, that’s equivalent to almost £3,000 a year for a couple retiring at 65.*

As Tom Stevenson from Fidelity says: “Someone earning £45,000 would not consider themselves a ‘fat cat’ by any means but they would be caught by this measure and rightly feel aggrieved about the way in which their attempt to make prudent provision for their retirement is viewed by the Government.”

Yes, £7 billion is a lot of money. But it’s also really important that as many people as possible save as much as they can for their retirement. If people don’t save for their old age, the Government will have to foot the bill, and that’s something that future taxpayers can ill afford.

I suspect that George Osborne is far less keen on this idea than the Lib Dems, so let’s just hope he holds firm and doesn’t abolish higher rate relief.

Don’t do it, George!

*This illustration assumes investment growth of 5% a year.

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