The current pension tax relief structure is unfairly weighted towards the best off. Now is the time to change it.
In the run up to the election, there has been plenty of talk about pensions, which has been refreshing.
However, it has been dominated by debates of whether to keep the triple lock or not. While this is undoubtedly an important issue, there is in our view a much bigger one, and it’s one that the Liberal Democrats have recognised.
It’s time for the Government to dramatically shake up the way that pension tax relief works and bring in a new, flat rate for all.
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How pension tax relief works now
At the moment, when you make a contribution into a personal pension, you benefit from tax relief from the Government. Essentially, the money you pay in gets bumped up by the taxman.
However, the exact amount of tax relief that you get varies depending on your Income Tax band. So, basic rate taxpayers get 20% tax relief; in other words, for every £1 that goes into your pension, you are actually paying 80p.
This system means that higher and additional rate taxpayers get even more tax relief, of 40% and 45% respectively. So that same £1 contribution costs higher rate taxpayers 60p and additional rate taxpayers just 55p.
Why we need a flat rate
First off, it’s great that we get tax relief on our pension contributions. There is no doubt that as a nation we simply aren’t saving anywhere near enough to cover our living costs in retirement, and this tax relief is an enormous selling point to pension contributions.
Without having some form of relief in place, savers may be even less inclined to contribute to a retirement fund than they already are.
But let’s be honest, the current system isn’t fair. Why on earth is the level of tax relief determined by our Income Tax band? Why does HMRC hand over millions of pounds a year giving higher and additional rate taxpayers’ pensions an even bigger boost than basic rate taxpayers?
It’s not like their pensions need a more significant helping hand; if anything, those taxpayers are more likely to benefit from a more generous employer contribution to their pension anyway.
The Government is right to give pension contributions a boost. But that boost should be the same across the board, rather than unfairly weighted towards the best off.
It would give basic rate taxpayers a boost
If a flat rate was brought in, it’s highly likely that the Government wouldn’t set it at the current 20% basic rate of tax. When then-Chancellor George Osborne was mooted to be considering such a switch last year, most industry experts predicted a flat rate would be set at around 30%.
Not only would this be fairer than the current system, it would also represent a significant improvement for basic rate taxpayers.
Saving money
[ADVERT] It isn’t just a question of fairness though. Switching to a flat rate would also save the Government a significant amount of cash. Given the precarious state of the nation’s finances, that strikes us as an excellent idea.
Obviously, higher and additional rate taxpayers would take a hit.
Those £1 pension contributions would cost 70p for everyone, and when you’re talking about significant payments into your pension, that difference can quickly add up to something substantial.
For example, a higher rate taxpayer looking to add £10,000 to their pension would need to find an extra £1,000 of their own cash than under the current system.
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What have the Liberal Democrats said?
In its manifesto, the Lib Dems have committed to investigating the feasibility of a flat rate.
It states: “We will establish a review to consider the case for, and practical implications of, introducing a single rate of tax relief for pensions, which would be designed to be simpler and fairer and would be set more generously than the current 20% basic rate relief.”
Now, let’s be honest, it doesn’t really make a huge difference what the Lib Dems say. They aren’t going to win, and they have ruled out the possibility of a coalition, so in practical terms their manifesto is really just a work of fantasy.
But that doesn’t mean it is without merit. We are already spending between £20 billion and £50 billion a year on pension tax relief (depending on who you ask).
We can cut that while making the system much fairer at the same time. That seems like a compelling argument to us.
Want more? Head over to our full loveMONEY election manifesto.
Read more detailed pledges:
Time to adjust Council Tax bands
Combine Income Tax and National Insurance