Tax  

Flat rate relief could see high earners £85k worse off

Flat rate relief could see high earners £85k worse off

Rumours have resurfaced that the chancellor is looking to move to a 25 per cent flat rate for pensions tax relief, which could lead to higher earners significantly losing out.

Analysis from Aegon, published today (November 24), found under a flat rate of 25 per cent, a basic rate taxpayer paying £100 a month into their defined contribution pension would see this topped up to £133.33 rather than the current £125, an extra £8.33. 

However, a higher rate taxpayer who currently sees their £100 increased to £166.66 would see this reduced by £33.33.

Under current rules, tax relief is linked to the amount of income tax paid on the full earnings before tax.

Basic rate taxpayers, with taxable income between £12,501 and £50,000, receive 20 per cent tax relief while higher rate taxpayers receive 40 per cent tax relief and additional rate taxpayers earning over £150,000 get 45 per cent relief.

How contributions would be increased if government moves to 25 per cent flat rate:

Income tax rate

Current

25% flat rate tax relief

20%

£125

£133.33

40%

£166.67

£133.33

45%

£181.81

£133.33

Source: Aegon

Under a 25 per cent flat rate, a basic rate taxpayer on average earnings of £27,000, paying 4 per cent of take home pay from age 22 through to their state pension age (68), could see their pot increase from £319,000  to £340,000. 

But a higher rate taxpayer aged 35 earning £60,000, paying the same 4 per cent of take home pay, would see their savings fall from £424,000 to £339,000 – a drop of £85,000.

Steven Cameron, pensions director at Aegon, said the proposed flat rate was seen by many as a "fairer way of sharing this government incentive across people of all earnings bands but would also likely produce a cost saving for the Treasury. 

“It would be good news for basic rate taxpayers who’d receive a more generous bonus but would create a big dent in the future pension pots of higher and additional rate taxpayers unless they increased their contributions.”

Savings under a 25 per cent flat rate of pensions tax relief:

 

Basic rate taxpayer aged 22 earning £27,000

Higher rate taxpayer aged 35 earning £60,000

Projected pension fund – current system of tax relief

£319,000

£424,000

Projected pension fund – 25% flat rate tax relief

£340,000

£339,000

Difference

Gain of £21,000

Loss of £85,000

Source: Aegon

Mr Cameron added that before moving to a flat rate system, the government would have to figure out how it would work for defined benefit schemes.

He said: “Here, the pension benefits they receive are based on their final or career average salary and not on the amount their contributions grow to after tax relief and investment growth.

“For consistency with those contributing to defined contribution schemes, higher and additional rate taxpayers in defined benefit schemes might see their and their employer’s contributions taxed as a benefit in kind, increasing their tax bills.”

Support for tax reform

The threat of changes to pensions tax relief has been on the cards for a while but resurfaced as the government looks to recover its Covid-19 debts. 

Earlier this year (February 10) former chancellor Sajid Javd was eyeing cutting high earner’s relief to 20 per cent.

There has also been a revival of the debate around the introduction of a 30 per cent flat rate of tax relief, or of turning the system on its head altogether so relief is given at the point of withdrawal rather than saving.