Alongside today's Budget, the Government launched a consultation on whether to turn the taxation of pensions on its head by replacing upfront tax relief on pension contributions with tax-free pension payments.
David Robbins, a senior consultant at Towers Watson, said:
"Currently, pension contributions can be made from pre-tax income but three-quarters of withdrawals are taxable. If all contributions were taxable and all withdrawals tax-free, one quarter of the money saved in pensions would no longer be exempt from tax both on the way in and on the way out. That is equivalent to abolishing the tax-free lump sum for future pension savings. Also, people would no longer be able to turn 40% tax into 20% tax or 20% tax into 0% tax by deferring income until retirement.
"Essentially, the Government is asking whether the tax-free lump sum and the benefits of tax deferral should be replaced with a government top-up, without offering any clues as to how big this would be. It's easy to imagine pension tax incentives becoming easier to understand but less valuable – for young people, that would mirror the Government's reforms to the State Pension. However, money saved in pensions would still be treated more favourably than money saved in ISAs, retaining an incentive to lock money away until retirement.
"If the top-up contribution were paid at the same flat rate for everyone, 40% taxpayers would be the big losers – it's easy to come up with examples where they lose out unless the Government adds well over 40p to each £1 they contribute from post-tax income. Depending on how cheap the Government wanted the new system to be, basic rate taxpayers could conceivably gain. But everyone would have to trust future tax-hungry governments not to come back to their pension pots for a second helping.
"The consultation asks how employer pension contributions should be treated under this sort of regime. Almost certainly, individuals would have to pay tax on employer contributions at the time they are made – otherwise employer contributions would be tax-free at both ends. Would HMRC siphon off part of the employer contribution before it reached the pension pot, or take more out of people's pay packets? If employer contributions are taxable income, would that be allowed to push people earning just under the higher rate threshold into 40% tax? And how would defined benefit accrual be valued when calculating the tax owed by millions of public sector employees?
"To implement the change, pension schemes would have to segregate 'old pensions' from 'new pensions' – so that only savings that benefited from tax relief upfront get taxed on the way out. If the Government wanted to bring forward even more revenue, savers could be invited to pay a one-off levy now and then be able to access everything tax-free. This could even be made compulsory.
"An ageing population will do enough to depress future tax revenues without the Government taxing tomorrow's pension incomes today. Anything that makes headline borrowing numbers look healthier by bringing forward tax revenues risks leading politicians into temptation – would they really run bigger surpluses to take account of how much less tax they can anticipate collecting in future?
"During the election, the Conservatives said that, once they have tapered down the Annual Allowance for high earners, 'the pensions tax relief system will be fair and affordable and we will not propose any further changes to the system during the next Parliament'*, and the consultation paper does stress that the Government may ultimately choose to stick with the current system rather than turning it upside down. The fear has to be that the Government could make a change for the wrong reasons – because it wants tax revenue sooner rather than because the new system would be any better."
*Special Brief: Taking the family home out of inheritance tax, Conservative Party, 11 April 2015