Neil MacGillivray: Weathering a DC pensions tax storm

With changes to defined contribution pensions on the horizon, Neil MacGillivray looks at the burden this could bring on investors who pay higher or additional rate tax…

Rewriting the rules on retirement planning

During the summer, HM Treasury published a call for evidence around pension tax relief.

The premise behind the request is that certain low earning individuals do not enjoy tax relief on their pension contributions, whereas others do.

There are three ways in which personal contributions to a pension can obtain tax relief; a net pay arrangement, relief at source (RAS) and gross contributions. These relief methods have evolved over time with net pay and RAS becoming the main modes.

A net pay arrangement works on the basis that an individual receives tax relief at their marginal rate when pension contributions are taken out of their pay, by their employer, before income tax is calculated. This gives the appropriate level of tax relief immediately.

The downside of this method is that for low earners, where their pay after the deduction is below the personal allowance, they either don’t receive any tax relief or they only receive tax relief on part of the contribution.

The introduction of personal pensions in 1988 required a new method of administering tax relief. The RAS method, whereby contributions to personal pensions by individuals are made from income that has already been taxed, has become the default choice of tax relief for pension schemes since 2006. However, an employer through an occupational pension scheme can elect to use a net pay arrangement if they wish.

As RAS operates on the basis that the individual makes their contributions out of net income, and they are entitled to tax relief on those net contributions paid to the RAS scheme up to the higher of their relevant UK earnings, or £3,600. Regardless of whether tax has been paid, or at what rate, an individual’s eligible contribution to a RAS scheme is treated as if an amount equal to basic rate tax has been deducted from the contribution.

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The scheme administrator recovers the basic rate relief from HM Revenue & Customs (HMRC) and adds it to the member’s pension pot. If the individual is a higher or additional rate taxpayer then they claim the remaining relief through their tax return.

The RAS does create something of a favourable anomaly for those who are low earners, when compared to a scheme that operates on the net pay basis. A low earner, who pays no income tax, and who is a member of a pension scheme that operates RAS still receives basic rate tax relief. Take this example:

John is a low earner, with relevant UK earnings of £10,000 and no other source of income. He wishes to save £1,000 gross to a pension.

If he’s a member of a company’s pension scheme which operates on the net pay basis then over the tax year he makes gross personal contributions of £1,000 and has a remaining salary of £9,000.

If on the other hand John is a member of a company’s pension scheme which operates RAS then over the tax year he makes personal contributions to the pension of £800 net (£1,000 gross), making his ‘take home’ pay £200 higher. However, more of his personal allowance would be used up.

It is estimated that 1.5m low earners in net pay arrangements are disadvantaged in this manner. The issue has also, perhaps, been exacerbated by the limits set for auto-enrolment, with the earnings trigger amount for automatic enrolment currently set at £10,000, while the personal allowance is £2,500 higher.

The Treasury’s document puts forward four possible options, but effectively dismisses three. This leaves the option mandating the use of RAS for all defined contribution schemes. This would ensure all low earners received tax relief top-ups, but it will require significant changes for schemes who currently use a net pay arrangement.

Another consequence of adopting this route is that for those who pay higher or additional rate tax it will create an additional burden; in that they would then have to claim the additional relief through their tax return.

With the date for responses having just closed, it will be interesting to see how, or if, this progresses, but I get the impression that the winds of change have begun to blow.

Neil MacGillivray is head of technical support at James Hay