PENSIONS - 17.09.2020

Solving pension tax relief inequality

The Treasury has published a call for evidence suggesting solutions to the current problems with pension tax relief. What are these problems and what are the proposals to fix them?

The problems

There are two ways that tax relief is given to those saving into a workplace pension: relief at source (RAS) and net pay arrangement (NPA).

RAS , introduced in 1988 at the same time as personal pensions, operates by the pension provider using the pension scheme member’s NI number to make a claim from HMRC for 20% of the employee pension contribution as tax relief, that is then invested in the employee’s pension fund. Higher earners in RAS schemes have to claim their additional 40%, 45% or 46% (in Scotland) tax relief by contacting HMRC. Everyone in a RAS scheme gets 20% tax relief.

NPA doesn’t involve the pension provider, as the employee pension contribution reduces gross taxable pay in the payroll and therefore provides tax relief immediately at the employee’s highest marginal rate. But reducing gross taxable pay doesn’t provide tax relief through the payroll to people who aren’t earning enough to pay tax.

This problem is affecting over 1.5m people currently, with the number growing each year. Employees are auto-enrolled into a workplace pension scheme when their earnings exceed £10,000 per year, but don’t start paying tax until they exceed £12,500 per year. With the significant increase in the personal allowance in recent years, many more people have been affected by their employer’s choice of pension scheme and its tax relief arrangements. Note. All public service pension schemes operate NPA so they comprise a significant percentage of those affected.

Four solutions

  1. Paying a compensatory bonus to NPA members based on RTI data.
  2. A standalone charge on RAS scheme members to recover the tax relief paid to non-taxpayers.
  3. Employers having to operate multiple pension schemes to separate out NPA and RAS members, switching them each pay period.
  4. Mandating the use of RAS for defined contribution pension schemes.

The way ahead?

The government appears to favour Option 4 which is unsurprising because it’s the least complex, least expensive and least burdensome for HMRC, but very complicated for employers and the pensions industry. It also completely ignores the fact that the vast majority of the 1.5 million people who are impacted by this inequality are not in defined contribution schemes, but in public sector defined benefit (DB) schemes, so it wouldn’t solve the problem for them at all. The call for evidence says that it would be “challenging for DB schemes given their differing economic and cash-flow requirements” . It’s not clear at all what this means other than that they would also have to make claims for tax relief in the same way as all other pension providers have to do at the moment who operate RAS.

Devolution

One of the final points raised is the discrepancy that devolved rates of income tax have also created, as 20% tax relief is given automatically in RAS schemes this also overcompensates the 19% taxpayers in Scotland. So, as well as providing equality we need a solution that is devolution proof.

The government is considering how to compensate low earners who are losing out on pensions tax relief. The most likely option involves mandating the use of relief at source for defined contribution pension schemes, but this could be highly complex for employers to administer.

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