Ouch! New tax rules attack your pension

Proposed changes to pension tax relief will mean lower pensions for high earners.

The main reason why pensions are the ideal vehicle for saving for retirement is that you get tax relief on your contributions. In other words, when you put money into a pension, you get back the tax you’ve paid.

The joys of tax relief

Here’s how it works: let’s say you’re a basic-rate (20%) taxpayer who puts £2,000 a year of your net (after-tax) income into your pension. HM Revenue & Customs (HMRC) will then add enough tax relief to ‘gross up’ your contribution to its pre-tax level. In this case, HMRC will put in 20% of £2,500, which is £500.

Higher-rate (40%) taxpayers can claim further tax relief via their yearly tax returns or by contacting their tax office. Higher-rate taxpayers paying £2,000 a year into a pension get £500 added to their pension pot, plus an extra tax rebate of £500. Thus, in this example, a net contribution of £1,500 would lead to £2,500 being invested.

Fiddle, fiddle fiddle

Only one in 12 taxpayers (8%) pays higher-rate tax, so most workers get just 20% tax relief on their pension contributions. Nevertheless, the highest-paid workers in the country claim a huge amount of tax relief. Indeed, in the 2008/09 tax year, around a quarter of all pension tax relief -- a total of £28.4 billion -- went to a tiny number of taxpayers earning £150,000+ a year.

In order to tackle this ‘feather bedding’ of the rich, the previous Labour government started tinkering with tax rates and pension tax relief. First, it introduced a new 50% tax band which applied to those earning over £150,000 a year.

Also, from next April, it would have introduced ‘tapered’ tax relief, which restricted the amount of tax relief which high earners could claim, aimed at those earning £130,000+ a year. For the lucky few earning £150,000+ a year, pension tax relief is now restricted to 20% instead of the previous 40%.

All change, please!

Not content with the changes introduced by Labour, the coalition government is planning more tinkering. On 27 July, HM Treasury issued a consultation document on the future of pension tax relief. It proposed a lower limit on pension contributions of £30,000 to £45,000 a year on which full tax relief would be paid. At present, this ‘annual allowance’ is £255,000.

The consultation period for these proposals ended on 27 August, so feedback from HM Treasury should be forthcoming sometime soon. If implemented, these changes would come into force with effect from next April for the 2011/12 tax year.

Hence, although the coalition government aims to simplify the tax system, it’s actually making it a whole lot more complicated!

Unforeseen problems

One problem with introducing an annual limit of, say, £40,000 is that it could generate extra tax bills for members of guaranteed final-salary pensions. This is because employees whose pension entitlement in a defined-benefit scheme rose by more than the proposed 1/20th of this (£2,000) in one year could exceed their annual contribution limit and generate a personal tax bill.

Recent question on this topic

• Lozza72 asks:

  New job - no pension scheme - what to do next?

  • 
    MikeGG1 answered "The bad news is that you are likely to have a State Pension Age of 70, but that means you have over..."
  • 
    Lozza72 answered "OK, thanks Mike - sounds like sensible advice.  Will have a look at those ISAs and get saving!..."
  • Read more answers

Thus, if the switch to a lower yearly contribution limit for pensions does happen, then it could be another nail in the coffin of final-salary schemes. This change could encourage employers to switch to less attractive defined-contribution schemes, which would mean lower pensions for employees.

In addition, the proposed changes could potentially affect how employers deal with promotions, pay rises, ill-health or early retirement, and being made redundant. Hence, the impact of the proposed changes to pension tax relief could hit far more workers than initially expected. Indeed, it could harm workers earning half of the £130,000 at which pension tax relief is currently throttled back.

Plan ahead before it’s too late

Finally, if you think that your retirement planning is likely to be affected by these proposed changes, then don’t sit back and await developments. Instead, check what the impact will be on your pension and then seize the opportunity to maximise your tax relief before the new regulations come into force. Otherwise, you could lose valuable addition tax relief in the 2010/11 tax year!

More: Start saving for a rainy day | 12 million face pension cuts | Turn your kids into millionaires