Tax relief for pensions could be cut

Tax relief at risk

Reducing tax relief on pension contributions or cutting it altogether is a perennial debate, but this year it has much greater momentum because the government needs to raise vast sums of extra tax to meet the cost of coronavirus. It’s estimated that pension tax relief is worth around £40 billion per year which would make a big dent in the country’s debt.

Basic or higher rate relief

One criticism of pension tax relief is that it favours higher rate taxpayers. Ignoring the tax-free lump sum allowed when starting to draw pension savings, individuals receive tax relief on contributions at up to 45% while often paying only 20% on their pension income. Conversely, again ignoring the tax-free amount, basic rate taxpayers get 20% tax relief on their contributions but mostly pay at the same rate on their pension income.

Solutions

One way to level the playing field would be for the government to limit all pension tax relief to 20%. This has been proposed but rejected several times before but this time the need to raise tax makes it far more likely to be given the thumbs up in the Autumn Budget.

Tip. To dodge any reduction in tax relief for pension contributions, consider making extra payments now instead of later, especially if you’re a higher rate taxpayer.

Tip. Where you meet the conditions, consider paying into a lifetime ISA (LISA). The tax benefits can be as generous as those for pension savings.

LISA details

You can start a LISA if you’re between 18 and 40. You’ll receive a bonus from the government (the tax incentive) on up to £4,000 of investment per year up to age 50. You can take your money at any time but you’ll lose the government bonus on the funds you withdraw before you’re 60 unless you use them towards the purchase of your first home (as long as it costs no more than £450,000).

Pension and LISA differences

The most significant differences are the tax consequences when you cash in your investment. Pension savings. While 25% of the money you take is tax free, the balance is taxed as income. To put it another way, 75% of the tax relief you received when you invested is clawed back, as is the same proportion of the growth in value of your savings (which was tax free while in the fund). LISAs. All money you take from your LISA is tax free if you stick to the conditions described above.

Tax comparison. Considering the tax position alone for each type of investment, LISAs stack up favourably against pension savings unless you pay tax at the higher rates at the time you invest but at a lower rate when you withdraw your money. Tip. You’re allowed to invest in both pensions and LISAs so you can get the best of both worlds.

The table below shows how much you would have to invest to get back £100. As you can see, LISAs compare well in most cases.