Higher earners saving for retirement will pay the price for the Chancellor’s Inheritance Tax reforms.
With the general election out of the way, the path was clear for the summer Budget to confirm the implementation of some of the new government’s more contentious manifesto pledges. One of these is to lift some wealthier families out of Inheritance Tax (IHT), with the cost to the Exchequer eased by restricting some of the £34 billion a year paid in tax relief on pension contributions1.
The Conservatives gave fair warning that, in the event of an outright election victory, pension tax relief for the highest earners would be targeted in order to pay for its IHT promises.
In many ways then, Chancellor George Osborne simply proved that he was sticking to his guns, but the news will still come as a blow to higher earners who were looking to the future to build a significant pension pot.
Under the new system, the Chancellor will trim back the amount of pension tax relief top earners can claim. If your income is over £150,000, the amount you will be able to invest into a pension each year and receive 45% tax relief from – known as the ‘annual allowance’ – will be gradually tapered from £40,000 to £10,000 on a sliding scale.
The new arrangement means the £40,000 annual allowance reduces by £1 for every £2 of earnings between £150,000 and £210,000. It means that for those at the top of the scale the lost tax relief could amount to £13,500 a year. Whilst there will be arguments over whether it is a fairer system, there’s no doubt that it is a more complicated one.
However, there is a window of opportunity for such individuals. Because the changes won’t be brought in until 6 April next year, top earners could bring forward pension contributions and benefit from tax relief under the current rules.
Tax relief for basic and higher rate taxpayers of 20% and 40% respectively will continue to be available on up to £40,000 of pension savings each year, without any complicated earnings-related sliding scale.
The former pensions minister, Steve Webb, had floated the idea of a 33% flat rate for everybody, which, it was argued, would have made the system more equal, not to mention simpler.
Ian Price, divisional director at St. James’s Place, says the fact that the Chancellor didn’t announce such a scheme will be good news for higher rate taxpayers, but “Basic rate taxpayers may be left feeling somewhat disappointed.”
Next year’s reduction in the annual allowance for top earners follows in the wake of the previous announcement that the lifetime allowance – which places a limit on the overall value of all the pension savings you can have – will fall from £1.25 million to £1 million in April 2016. Pensions above this limit will lose valuable tax relief and suffer a 55% tax rate when they are withdrawn.
However, more encouragingly, it has also been confirmed that from April 2018 the Lifetime Allowance will increase annually in line with CPI inflation.
“It’s clear that restrictions on government spending, at least where pensions are concerned, will be felt by those with greater capacity to save for later life,” says Price.
He advises those who pay the top rate of tax, or who are close to the lifetime allowance, to speak with a pension specialist. “Higher earners who are saving into a personal or workplace pension should seek advice to determine whether or not they should continue to do so, or if there are other tax-efficient investments they should be looking at.”
Price also recommends those who are close to paying the top rate of tax should understand the effect that additional earnings could have on the level of pension savings they can make.
But he argues that no one should be put off from saving into a pension. “The changes don’t take away the fact that pensions remain exceptionally tax-efficient investment wrappers for anyone interested in building a secure future.”
Pensions like ISAs?
The Treasury also published a green paper on transforming the way pensions are taxed. “Pensions could be taxed like ISAs,” Osborne said in his Budget speech. “You pay in from taxed income – and it’s tax-free when you take it out. And in-between it receives a top-up from the government. This idea, and others like it, need careful and public consideration before we take any steps.”
The Chancellor has limited the amount of tax relief paid to higher earners, but it seems clear he wants to go further. “All the signs are he has not finished tinkering with pension legislation,” observes Price. “The message is simple: save as much as you can as soon as you can into your retirement fund because the future is uncertain.”
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1 www.gov.uk., Personal Pension Statistics, HM Revenue & Customs, figures for 2013/14, February 2015