“Flat-rate tax top-up for pensions is fundamentally fair, efficient and means many of the existing rules can be scrapped”
In the run-up to his first Budget, many people are hoping that Sajid Javid will sort out the mess of tax rules on pension savings.
At a technical level, the tangle can be easily untangled – simply move to a flat-rate of tax top-up, for all pension savings, both defined contribution and defined benefit. The rate would be set to be neutral for the Chancellor – say 30 per cent – and would apply to total employee and employer pension savings.
A flat-rate system is fundamentally fair, because every taxpayer gets the same percentage tax top-up for each pension pound saved. It is also efficient, encouraging the lower paid, including part-time workers, to save for their retirement and helps close the “gender pension gap”.
It also cuts right through the Gordian knot of tax rules for the top 1 or 2 per cent of very high earners – especially NHS consultants – which we have heard so much about recently.
But flat-rate has winners – the 80 per cent of people earning less than £50,000, paying 20 per cent basic rate income tax, who could get a bigger top-up, and losers – the 20 per cent earning over £50,000, paying 40 per cent higher rate income tax, who would get a smaller top-up.
At the moment, people receive a tax top-up on pension savings at their marginal tax rate, with tax free investment returns. At retirement, a quarter of the pension can be taken tax free, with the other three-quarters taxed at the marginal rate.
But this system is heavily biased in favour of higher rate 40 cent taxpayers – for each pension pound saved they get a much bigger end-to-end tax benefit than basic rate 20 per cent taxpayers, and is inefficient, encouraging pension savings by the higher, not the lower paid.
The rules limiting pension tax relief are complex for the top 1 or 2 per cent of earners – those with incomes, including pensions, over £150,000 a year. Some hospital consultants are refusing to do extra shifts over their contracted hours and the doctors’ trade union, the British Medical Association, has been furiously lobbying for these rules to be scrapped.
Someone now earning £30,000, saving 15 per cent of salary into a defined contribution pension – say 5 per cent their own contribution and 10 per cent employer contribution – is saving £4,500, so currently gets a 20 per cent tax top-up of £900. With flat-rate they would get a 30 per cent tax top-up of £1,350, or £450 more.
The mechanism to do this is very simple, their £12,500 personal allowance – how much they can earn tax free – is just moved up by £2,250 to £14,750, reducing tax payable by £450.
Someone earning £60,000, also saving 15 per cent of salary in their pension, is saving £9,000 and now gets a 40 per cent tax top of £3,600. For each pension pound saved they get double the top-up of the 20 per cent taxpayer.
With flat-rate they would get a 30 per cent tax top-up, £2,700, or £900 less. Their personal allowance is moved down by £4,500 to £8,000, increasing their tax by £1,800. This effectively pays the higher tax top-up for two people each earning £30,000.
The same flat-rate mechanism of adjusting the personal tax allowance would apply to defined benefit pensions – based on salary and years worked— rare as hens’ teeth in the private sector, but standard in the public sector.
Public sector defined benefit pensions are much more generous than private sector defined contribution, so the annual pension saving – the employee and employer contribution – is much higher – around 30 per cent of salary, and the impact of 30 per cent flat-rate top is also much higher.
With flat-rate, the “annual allowance” and “taper”, affecting very high earners with generous defined benefit pensions – especially NHS consultants – would be scrapped, along with the “life time allowance” for future pension savings.
Tax free investment returns, income tax on pensions and 25 per cent tax free would be unchanged.
People could choose how much to save in their pension. Some highly paid public sector workers, especially NHS consultants, who expect to pay 40 per cent tax in retirement, won’t want to save into a pension, even taking tax free returns and 25 per cent tax free into account.
To give them flexibility, public sector pension scheme rules should be changed to allow people to opt out and receive higher pay instead, and pay income tax and national insurance.
Moving the highest public sector earners away from defined benefit pensions also starts to close the (unsustainable) gulf with private sector defined contribution, and reduces the bill we are passing on to our children and grandchildren.