Do you need to take steps before this year’s Budget to minimise potential future tax bills?
A number of financial experts believe that Chancellor George Osborne is planning to take drastic steps when it comes to how pension contributions are taxed – and they say that the only way to beat a crackdown could be to take urgent action ahead of the 16 March speech.
Changing the tax-relief system
So what might Osborne have up his sleeve? For the past few weeks, Treasury officials have been discussing the prospect of changing the tax-relief system on pension contributions.
At the moment, any money saved in a pension is treated by the government as if it came from pre-tax income. Imagine you are a basic-rate taxpayer and you put some of your take-home pay – which has already been taxed at 20% – into your pension. This money is currently subject to tax relief, which means that for every £80 you save, the government rounds it up to £100.
Issues with the current system
One issue with this system is that people who pay higher rates of income tax get bigger incentives to save: for higher-rate taxpayers at 40%, the effective cost of £100 in pension contributions is £60, while for top-rate taxpayers it’s just £55.
While the way in which tax relief is applied at present is certainly simple, there is a strong argument for saying that higher earners should not continue to receive such a large subsidy from the state, running into billions of pounds a year.
Cuts in pensions tax relief are ‘close to certain’
So although nothing is guaranteed, the forthcoming Budget seems most likely to go one of two ways: either tax relief at the higher rates will be abolished entirely, or a new rate – say 25% or 30% – will be brought in across the board. Investment firm Hargreaves Lansdown says some form of cut in relief for higher earners is “close to certain”.
How you could soften the impact of any changes
So if you pay income tax at 40% or above, what can you do to soften this blow? It is very likely that any new limits on relief will apply, if not immediately on 16 March, then from the start of the new financial year on 6 April. That means higher earners have a couple of weeks, and at most a month, to increase their pension payments in order to benefit from the current, more generous regime.
If you pay income tax at 40% or 45%, it might be worth making a large lump sum pension contribution now if you can afford it – even if you have to suspend your monthly pension payments for a while after March, you will still benefit from the higher rate of relief.
Will tax relief be scrapped altogether?
Some analysts have suggested that tax relief could be scrapped altogether, with pension moving to an ISA-style system in which savings are taken out of post-tax income but with no tax applying to withdrawals. If this came to pass, the benefits of making pension extra contributions now could be even greater.
Of course, there is always a chance that the system may remain unchanged or that reforms will take a different shape. As such, only make extra contributions now if doing so will not overstretch your finances.