Income tax cuts come with ‘a sting in the tail’ for pension savers who will see Government top-ups to their contributions reduced, say finance experts.
The reduction in the basic rate from 20 per cent to 19 per cent, and the abolition of the 45 per cent top rate, will benefit taxpayers in terms of take home pay but have a knock-on effect for pensions.
Taxpayers will no longer get an automatic 25 per cent top up to money paid into pensions to cover basic rate tax relief – taking them back to where they were before 20 per cent tax was charged – and will instead see a lower 23 per cent boost.
It could cause a rush of extra pension contributions, especially by higher earners with the most to gain, ahead of changes in April 2023, although some basic rate taxpayers will get an extra year’s breathing space due to technical transitional arrangements.
Income tax and pension tax relief: Changes could cause a rush of extra pension contributions, especially by higher earners ahead of April 2023
Pensions tax relief allows everyone to save for retirement out of untaxed income. That means you get a bigger sweetener the more you earn.
The rebate or ‘top up’ is based on people’s income tax rates – that is 20 per cent, 40 per cent or 45 per cent, until Chancellor Kwasi Kwarteng’s changes take effect.
‘The reduction in the basic rate of income tax from 20 per cent to 19 per cent will be good news for millions of individuals,’ says Steven Cameron, pensions director at Aegon.
‘There is a slight sting in the tail regarding pension contributions. Individuals receive a “tax relief” top-up based on their “highest marginal” rate of income tax.
‘Currently, the “net” cost to an individual of investing £100 in their pension is £80 as when paying 20 per cent income tax, their pension receives a £20 top-up from the tax man.
‘In future, a 19 per cent income tax rate means you’d need to pay in £81 from take-home pay to have £100 invested in your pension. So if individuals continue to pay in £80, their pension will benefit from a slightly lower £98.75.
‘While the change in income tax rate is from April 2023, pension schemes which collect pension tax relief for their members using what’s referred to as “relief at source” are being granted an extra year to continue to collect at the 20 per cent rate.’
What is relief at source?
Employers and their pension providers have two options when handling pension tax relief for staff.
Net pay means workers contribute directly into their pension before their tax bill is calculated, so their pension tax relief is already included and there is no need to claim it from HMRC.
Under relief at source the pension provider claims the income tax relief directly from HMRC and adds it to each worker’s pension.
This is Money’s pension columnist Steve Webb explains in more detail here.
Meanwhile, the abolition of the 45 per cent additional income tax rate for those earning above £150,000 will also affect their tax relief top-ups and they may want to boost contributions while they still can, according to Cameron.
‘Currently, high additional rate taxpayers can receive 45 per cent tax relief. Put another way, a contribution of £550 out of take-home pay becomes £1000 when invested in a pension. In future, the highest marginal rate will be 40 per cent so the same £1000 in a pension will cost £600 from take-home pay.
‘Those in a position to do so may want to make additional pension contributions before April 2023 to make sure they benefit from the maximum tax relief. We recommend seeking professional financial advice.’
Cameron notes that even with slightly lower tax relief, pensions still remain a particularly tax efficient investment, and those in work schemes get a generous top-up from their employers too.
James Jones-Tinsley, a pensions specialist at Barnett Waddingham, says: ‘For consumers, the cut in income tax to 19 per cent is a double-edged sword.
‘It is an immediate gain in income with a long-term sting in the tail from a smaller pension. The one per cent loss may sound inconsequential, but it compounds over a working lifetime – as Einstein said, it’s “the eighth wonder of the world” and those who don’t understand it, pay the price.
‘Individuals now need to increase their personal contributions just to stand still; this might not be a tempting prospect with climbing interest rates and rising inflation.
‘Nothing in the Chancellor’s speech spoke to the UK’s looming retirement crisis – there’s only so long the Government can kick this can down the road.’
Claire Trott, a retirement expert at St. James’s Place, says: ‘The announcement that the income tax reduction of 1 per cent of the basic rate to 19 per cent is being brought forward may drive people to consider if now is the time to maximise pension contributions or if holding fire makes more sense.
‘However, for those who are additional rate tax payers, the remainder of this year will be the last chance to get 45 per cent tax relief. That said they won’t be paying 45 per cent tax next year.
‘The overall tax relief for higher rate tax-payers is likely to remain the same but if contributions are paid to a personal pension then less will go into the pension and more into your pocket when the reduction occurs.
‘This isn’t the same for most occupational pension schemes where the contributions are paid before tax.
‘For low earners though, the reduction in relief will be real terms reduction in their pensions. For a non-tax payer they currently get 20 per cent tax relief, up to their earnings or £3,600 if more.
‘This will be reduced to 19 per cent when the basic rate drops for some, although there is a transitional period for personal pensions.
‘This hits those least able to save the hardest. For those who are in auto enrolment schemes, depending on their structure this could mean increased contributions taken from pay packets.’
AJ Bell says that for basic-rate taxpayers, lowering income tax from 20 per cent to 19 per cent will cut the effective pension saving “bonus” provided by tax relief from 25 per cent to around 23 per cent.
It explains that for additional-rate taxpayers the income tax rate reduction from 45 per cent to 40 per cent will see this savings bonus drop from around 82 per cent to 66 per cent.
The firm offers the following examples, which assume the saver is a member of a relief at source scheme. It notes that members in net pay schemes will have the full amount of tax relief paid automatically unless they are a very low earner.
Under the current system:
• Basic-rate taxpayer – pays in £80, gets £100 in their pension (20% tax relief, 25% bonus)
• Higher-rate taxpayer – pays in £80, gets £100 in their pension, claims back £20 (40% relief, 66% bonus)
• Additional-rate taxpayer – pays in £80, gets £100 in their pension, claims back £25 (45% relief, 82% bonus)
Under new tax rates – once fully implemented:
• Basic-rate taxpayer – pays in £81, gets £100 in their pension (19% tax relief, 23% bonus)
• Higher-rate taxpayer – pays in £81, gets £100 in their pension, claims back £21 (40% relief, 66% bonus)
• Additional-rate taxpayer – pays in £81, gets £100 in their pension, claims back £21 (40% relief, 66% bonus)