Higher rate taxpayers face pension pot ‘dent’ under rumoured 25% flat rate relief

Writes Stephen Little

A new 25% flat rate on pensions tax relief would create a “big dent” in the pension pots of higher rate and additional rate taxpayers if it goes ahead, Aegon warns.

There are rumours that Chancellor Rishi Sunak is planning on reforming pensions tax relief so everyone receives a flat rate of 25%. If this happens, basic rate taxpayers will be better off while higher rate taxpayers could see their pension funds dip.

Aegon pensions director Steven Cameron said: “This is seen by many as a fairer way of sharing this government incentive across people of all earnings bands but would also likely produce a cost-saving for the Treasury.

“It would be good news for basic rate taxpayers who’d receive a more generous bonus but would create a big dent in the future pension pots of higher and additional rate taxpayers unless they increased their contributions.”

Basic rate taxpayers currently receive tax relief at 20% which means £100 from take-home ‘after-tax’ pay into a defined contribution pension is boosted to £125 after £25 bonus from the government.

Higher rate taxpayers receive 40% tax relief and additional rate taxpayers earning over £150,000 get 45% relief.

Under a flat rate of 25% tax relief, a basic rate taxpayer paying £100 a month into their defined contribution pension would see this topped up to £133.33 rather than the current £125, an extra £8.33. However, a higher rate taxpayer who currently sees their £100 increased to £166.66 would see this reduced to £133.33.

A basic rate taxpayer earning on average £27,000 and paying 4% out of take-home pay from age 22 through to their state pension age of 68 could see the fund from their contributions rise from £319,000  to £340,000.

In contrast, a higher rate taxpayer aged 35 earning £60,000 paying the same 4% from take-home pay would see the fund from their contributions fall from £424,000 to £339,000 – a drop of £85,000.

The higher rate taxpayer would need to increase their contribution out of take-home pay to 5% to have the same pension pot.

Cameron added: “Before implementing a move to a flat rate of pensions tax relief, more thinking is needed on how this would work for those contributing to a defined benefit or final salary scheme. Here, the pension benefits they receive are based on their final or career average salary and not on the amount their contributions grow to after tax relief and investment growth.

“For consistency with those contributing to defined contribution schemes, higher and additional rate taxpayers in defined benefit schemes might see their and their employer’s contributions taxed as a benefit in kind, increasing their tax bills.”