Labour is proposing to limit student tuition fees to £6,000, paid for by curbing the annual amounts the well-off can put into pensions and obtain tax relief. But what does this mean in practice for people saving for retirement?
We explain how the tax relief works, what it is worth, and what the major political parties are proposing.
What cuts to tax relief are Labour planning?
The two cuts announced by Labour are:
• To reduce the amount you can pay into a pension and get tax relief on over your lifetime from £1.25m to £1m.
• To reduce the amount you can pay into a pension and get tax relief on each year from £40,000 to £30,000.
Ed Miliband also confirmed a previously announced plan to axe pension tax relief for those earning over £150,000, cutting it from 45% to 20%. Around 300,000 earn above £150,000, so the cost will fall on them.
How does pension tax relief work?
When you make a contribution to a pension, the money that goes in is not taxed. If you are a basic-rate taxpayer (ie: you earn less than £41,450) you earn 20% tax relief on everything you put in. In other words, if you pay £100 a month in, then it only costs you £80 a month from your pay.
If you are a higher-rate taxpayer, the tax relief is much better. For every £100 you pay in, it only costs £60 from your pay as you receive tax relief at the 40% rate. At the top end, it’s even more attractive. If you earn more than £150,000 a year, you pay 45% tax on income above that level. But if you put £100 into a pension, then it only costs £55 after the tax relief.
The other major tax relief with pensions comes when you retire. You are allowed to take 25% of anything you have saved entirely tax free (although you have to be over the age of 55). For example, if you have saved £500,000, you can take £125,000 without paying a penny of tax.
The existing limits to tax relief
Both Labour and Tory chancellors have progressively reduced the amount the very well-off can gain in tax relief. The lifetime allowance was introduced in 2006 by then chancellor Gordon Brown, who capped the total sum any individual could save in a pension and qualify for tax relief at £1.5m. It gradually went up to £1.8m, then in 2012 George Osborne cut the maximum to £1.25m.
The annual limit was a generous £255,000 until 2010, when Osborne slashed it to £50,000 for the tax year beginning in 2011. He then cut it again to just £40,000 starting in tax year 2014/15.
If Ed Balls becomes chancellor and reduces the annual and lifetime caps, he will be following a path already taken by George Osborne. But expect it to be labelled in the rightwing press as a tax raid on the savings of the squeezed middle.
Will the caps affect me?
The lifetime and annual caps limit the total amount anyone can pay into a pension scheme and enjoy tax relief. Reducing the caps means high earners will not obtain as much tax relief as before.
A cut in the annual allowance to £30,000 would start to affect those earning much above £100,000 a year, particularly people in final salary type schemes
According to the financial advisers Hargreaves Lansdown, “a lifetime allowance of £1m would cap final salary scheme payouts at £50,000 a year and money purchase payouts at around £32,000 a year (based on an inflation linked annuity)” it said.
Tom McPhail of Hargreaves says many GPs already have more than £30,000 a year going into their pensions, so they will be hit by 40% tax on contributions above that level. In other words, if they put in £1, it will cost them £1, not 60p, making further contributions almost pointless.
Others it will affect are self-employed people who have lumpy income and in a good year put more than £30,000 into a pension for the tax benefits. This is likely to include a lot of IT contractors.
When the annual allowance was cut to £40,000 from £50,000, it was estimated it would hit the 100,000 people who were putting more than this into a pension scheme every year. Many more will be caught by the proposed reduction to £30,000.
People with final salary schemes who receive good pay rises could also be hit by a one-off tax charge. For example, if a person’s pay went up from £60,000 to £65,000 and they are in a 1/60ths scheme, it would in effect boost the final value of their pension and incur a tax charge of around £2,500.
But as Miliband pointed out in his speech, the vast majority of people will not be affected. He said the new £1m cap is set at 25 times the typical sum of money that the average worker builds up over their lifetime in a pension scheme.
The cost of pensions tax relief
Tax relief on pension contributions is worth £34.8bn a year. To put this into perspective, the budget for NHS England is around £95bn, while the total spend by the military is around £33bn.
It is estimated that around 70% of that £34.8bn in tax relief is taken by higher or top rate taxpayers. In other words, this is a subsidy that benefits the well-off far more than people on average pay.
Labour’s proposed caps are likely to shave around £1.5-£2bn off the total cost of pension tax relief.
Will it discourage people from saving for retirement?
Possibly. But the problem with retirement savings in the UK is not the well-off but the bottom 50% who are not saving enough. They are currently being auto-enrolled into workplace schemes, so pension scheme membership is currently on the rise for the first time in years. As the vast majority will be earning less than the 40% tax threshold, they won’t be affected by changes to reliefs proposed by Labour.
What are the other parties proposing?
Steve Webb, the pensions minister, is a Liberal Democrat, and is known to be in favour of removing the 20% and 40% rates of relief with one set at 33%. The idea has also won the support of former Tory Treasury minister Mark Hoban.
- This article was amended on 27 February 2015 to correct the name of the Treasury minister
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