Pension Planning – Changes on the Horizon?
March Update: Changes coming along the tracks
When George Osborne read his Autumn Statement and Spending Review to the House of Commons on November, there was a widely held expectation that changes to the tax rules surrounding investing in a Pension arrangement would be announced. His Budget statement in July 2015 raised the expectation, launching a consultation on the subject that was ultimately completed at the end of September. Alas, no announcement came, raising speculation further that come the next Budget Statement on 16 March 2016, significant changes will be announced.
The Need for Change
In 2013/14, the total cost of pension tax reliefs to the Exchequer was in the region of £45bn, whereas the amount of tax that is received from Pensions in payment is around £13bn, so the net cost of tax relief is over £21bn. Over two thirds of pensions tax relief currently goes to higher and additional rate taxpayers. (Source: “Strengthening the incentive to save: a consultation on pensions tax relief”, HM Treasury, July 2015). This is an expense that a cash strapped Chancellor could well do with saving.
So what are the options?
The current pension regime is known as “exempt, exempt, taxed” or EET. In other words, the Pension contributions attract tax relief, so are tax exempt. When the money is invested in a Pension arrangement, the growth is tax free, hence the second exemption. Finally, when pensions are paid out, up to 25% of the monies paid out is tax free, but the remainder is taxed as income. Tehrefore, the equivalent tax rate for a 40% tax payer is 30%, after allowance for the lump sum, and up to the equivalent of 15% for a basic rate tax payer.
This compares with an ISA, for example, which would be “taxed, exempt, exempt” or TEE. Money is invested out of taxed income, grows tax free, and is paid out tax free. A deposit account with a bank or building society would be “taxed, taxed, taxed” or TTT. In other words, invested out of taxed income, the bank pays tax while it holds your money (which restricts the amount of interest that they pay to you), and then you pay income tax on any interest that you receive.
Option 1 – To maintain the EET regime, but greater restriction on tax reliefs.
Unlikley, as this would be seen to hurt and disincentivise those important members of the electorate who are just in the 40% tax bracket. Alternatively and more likely, further restrictions to the Annual Allowance have been mentioned, possibly to £30,000 p.a. This would only be reasonable if rules for members of defined benefit schemes (like the NHS, University or Armed Forces schemes) are amended.
Option 2 – Tax Relief on a “Buy-two-get-one-free” deal
This is an option that is widely discussed. The average rate of tax relief currently paid is around 33% across the board. Consideration is being given to assuming this average rate on all pension contributions, so in effect, if an investor pays £200 into a Personal Pension, the government pays £100.
Option 3 – Launch of Pension ISAs or PISAs
This would involve the scrapping of Pensions tax relief altogether, and the EET regime would fall into line with the TEE regime associated with ISAs. This may, however, have unintended consequences. Those with existing pension arrangements that have had tax relief on monies invested in the EET regime, but then not be taxed when monies are withdrawn in the TEE regime. So, either members would leave old EET money in the EET regime and new contributions would be in the TEE regime. Alternatively, a solution put forward to Steve Webb, the former Liberal Democrat Pensions Minister, would be for everyone to move to the TEE regime, but with a “haircut” being applied to existing pension provision of around 20%. In other words, a one off tax would be levied on Pension funds to convert them to the TEE regime. This would be highly attractive to the Chancellor as the money raised could be used to pay of a massive one third of the national debt.
This, in itself, could reward the Exchequer with a huge £35bn annual saving, according to the Daily Telegraph on 28 January 2016.
New Pensions Minister, Baroness Ros Altman, has received much lobbying from the Pensions Industry not to go down this route, but if she does decide on this, that she also give consideration to the removal of the Lifetime Allowance, again, something first mooted by her predecessor before the General Election.
Worryingly though, such a tax charge would leave Pension funds having to liquidate massive assets. In other words, sell billions of pounds of stocks and shares, probably leading to a massive fall in stock market values. On balance, probably not a good idea!
Option 4 – Removal or Restriction of the Tax Free Lump Sum
For several years now, the Pension text books have stopped making reference to the Tax Free Lump Sum payable on retirement, replacing its name with the less user friendly “Pension Commencement Lump Sum” or PCLS, with no reference to its tax status. With the recently launched pension flexibility, pension funds can pay out more than the 25% than had hitherto been allowed, albeit that anything in excess of the 25% is taxed as income. Why must the lump sum be tax free? It seems that a bi-product of the pensions flexibility could be that the tax free status of the 25% PCLS could be restricted or removed.
Philip Booth, research director at the Institute of Economic Affairs and Professor of Finance, Public Policy and Ethics at St. Mary’s University, Twickenham, wrote in the Daily Telegraph on 03 February 2016
“Keeping the current system in principle but limiting tax-free cash to £25,000 would enable the Treasury to tear up pages of tax legislation designed to prevent abuse of pension fund tax relief because abuse would no longer be worthwhile. As it happens, this would also reduce hugely the benefits that flow to the rich from tax relief. That would be the policy of a reforming Chancellor who understood public finance and who did not believe that political manoeuvring should determine his every action.”
We do not know for sure that any of these options will be brought in. For years, investors have been warned about the possible removal of higher rate tax relief being around the corner. Now, more than ever before, we think that something is about to change.
What should you do about it?
If you have the potential for making a pension contribution, even if you have to move money from an ISA or other investment, consider making the investment before 16th March 2016 – it may be your last chance.
You must take advice however before taking such action, as a Pension investment now may affect your Annual or Lifetime Allowance.
MMM Partner, Ric Belcher, considers George Osborne’s July 2015 Budget statement which raised expectations that further changes to pensions were being considered by launching a consultation on the wide-ranging issue of the taxation treatment of all pension arrangements.
The consultation period ended in September this year and therefore it was something of a surprise that no further announcements on the topic were included in the recent Autumn Statement 2015 made to the House of Commons on the 25 of November 2015. The lack of comment in the Chancellor’s latest speech has led to speculation that far reaching changes could be announced at next year’s budget on 16 March 2016.
The case for change
In the tax year 2013/2014 the total amount of pension tax relief claimed was in the region of £45bn whereas the amount of tax raised from pensions in payment was around £13bn. The net differential, and consequent cost to the exchequer, therefore was approximately £32bn. It has also been noted that approximately two thirds of the tax relief granted was claimed by higher and additional rate taxpayers. (Source: “Strengthening the incentive to save: a consultation on pensions tax relief”, HM Treasury, July 2015).
So what are the options?
The current pension regime is known as ‘Exempt, Exempt, Taxed’ or ‘EET’. In other words pension contributions attract tax relief and therefore are considered tax exempt. The money invested in a pension arrangement also grows tax-free leading to a second exemption. Income taken from a pension is, however, taxed at an individual’s marginal rate. The effective tax rate for a 40% taxpayer is 30%, after allowance for a 25% tax-free lump sum, and 15% for a basic-rate taxpayer.
Option 1 – Maintain the EET regime, but restrict relief: any reduction in the rate of relief would be viewed as a disincentive to those in the higher tax brackets. The option being considered therefore is a reduction the maximum amount of relief available to an individual in any tax year (known as the Annual Allowance and currently set at £40,000) to £30,000. This could in turn create problems for members of defined benefit schemes (like the NHS, University or Armed Forces schemes) and so may prove difficult to implement.
Option 2 – Tax Relief on a “Buy-two-get-one-free” deal: the average rate of tax relief gained per individual is around 33% of the contribution paid. Consideration is being given therefore to adopting this rate on all pension contributions – the idea being that: ‘when an investor pays £200 into a personal pension the Government will top it up with a further £100’.
Option 3 – Launch of Pension Individual Savings Accounts (PISAs): this would involve the scrapping of pension tax relief altogether and falling into line with the regime associated with ISAs – ‘Taxed, Exempt, Exempt’ or ‘TEE’. Money is invested out of taxed income, grows tax free, and is paid out tax-free.
This option could, however, have unintended consequences as those with existing pension arrangements (in the EET regime) would have received tax relief at outset and would avoid tax when monies are withdrawn.
The suggestion is that members would leave existing pension funds in the EET regime and redirect new contributions into the TEE regime. Alternatively, a solution put forward would be for everyone to move to the TEE regime, but with a “haircut” being applied to existing pension provision of around 20%. In other words, a one off tax would be levied on pension funds to convert them to the TEE regime. This would be highly attractive to the Chancellor as the money raised could be used to pay off a massive one third of the national debt. Worryingly though such a tax charge could leave pension funds having to sell billions of pounds of stocks and shares leading to a sharp fall in stock market values.
New Pensions Minister, Baroness Ros Altman, has been lobbied by the pensions industry to avoid this route.
Option 4 – Removal of the Tax-Free Lump Sum: for several years now the ability to take a tax-free ‘Pension Commencement Lump Sum’ or ‘PCLS ‘from a pension arrangement has been threatened. The recent introduction of ‘Pensions Freedom’ which allows an investor to draw more than 25% of the fund by paying income tax on the excess has led many commentators to suggest again that the tax-free status of the 25% PCLS could be removed.
We do not know if any of these options will be taken forward. We do know, however, that consideration is being given to changing the current system of tax reliefs.
What should you do about it?
If you are considering making a pension contribution in 2016 it might be worth making it before Budget Day on 16 March 2016 or you might simply wish to review your current arrangements. Please remember to take professional advice before taking any action as a pension investment now may affect your Annual or Lifetime Allowance, which could have tax consequences.
Information is based on our current understanding of taxation legislation and regulations. Any levels and bases of, and reliefs from, taxation are subject to change.
A pension is a long-term investment. The fund value may fluctuate and can go down. Your eventual income may depend upon the size of the fund at retirement, future interest rates and tax legislation.