By Michael Summersgill, Chief Executive of AJ Bell
The Budget presents a perfect opportunity for the Chancellor to commit to a long-term Pensions Tax Lock, guaranteeing stability in pension taxation for at least this parliament.
Aspirational workers who set money aside decades before retirement, taking responsibility for providing for themselves once they stop working, should not be subject to endless speculation about how their own money may or may not be taxed.
Two proposals appear to have gained traction in recent months: implementing a single rate of pension tax relief; and capping tax-free cash at just £100,000.
Although superficially a single rate of relief might appear to be simple and fair, it is an idea which I am fundamentally opposed to.
Money paid into pensions is not exempt from tax, as the term ‘tax relief’ implies. In simple terms, pensions are taxed tomorrow, not today. Savers forego spending power now to give themselves financial muscle in the future. They are encouraged to do so by deferring income tax until the money is withdrawn in retirement.
Pension savers do not know what their tax liability will be when they take their pension in retirement, but they accept that risk knowing they opted to defer both the income and the associated tax. This also forces the Chancellor of the day to mirror the behaviour, foregoing some tax receipts today knowing future revenues will be bolstered and pensioners will have reduced dependency on state benefits.
Individuals are expected to spend their entire working life building a retirement pot based on the pension tax pact. A commitment is made in good faith that they will be rewarded for making sacrifices to provide for their retirement. Yet the tax treatment of pensions is amended with monotonous regularity.
When the Conservatives held the purse strings, rumours circulated that a pension tax raid could be on the cards, especially when George Osborne launched the Lifetime ISA, a quasi-retirement savings product effectively offering basic rate relief regardless of an individual’s marginal tax rate. The product has proved popular with aspiring homeowners but has had little impact on retirement saving.
Rachel Reeves might view pension tax as a relatively soft target. Likewise, some think-tanks argue imposing a cap on tax free cash – the right to take 25% of your pension untaxed – could be justified since it would only impact wealthier savers.
Moving the goalposts on pension taxation risks undermining trust in retirement saving. Instead, the Chancellor should publicly commit to a Pensions Tax Lock, promising not to tinker with the fundamentals of the pension tax system in this parliament, and laying down the gauntlet to any successor tempted to do so.
Scrapping higher rate tax relief on pension contributions would represent a breach of Labour’s manifesto promise not to raise taxes for workers. Millions would have to contribute more income tax if such changes were implemented.
What’s more, it endangers future investment. Those who fear the effect of double taxation on pensions – paying income tax on contributions and withdrawals – may in some cases stop contributing to their investments for fear they’ll be penalised in the long run, starving capital markets of much-needed cash.
The same applies to tax-free cash on pensions. The basic premise that most people can take 25% of their pension untaxed is still one of the key incentives underpinning pension saving.
For many, it is the means through which they plan to pay off their mortgage, paving the way for a debt-free retirement. For others, their tax-free cash will provide for the once-in-a-lifetime trip they’ve dreamed about their entire working lives.
Telling working people that they’re unable to access the pension tax breaks available to their parents – especially when they’re already confronting a less generous state pension with a later retirement age – is unpalatable.
Honouring its commitment to long-term stability with a Pension Tax Lock would signal that this government is serious about giving people the certainty and security to invest for the future with confidence.
Disclaimer: These articles are for information purposes only and are not a personal recommendation or advice. Tax and pension rules apply.