The potential pension tax traps in the Autumn Statement

08 November 2022

Net pension tax reliefs cost the Treasury an estimated £48.2bn in 2020/21, up £3.7bn compared to 2019/20. Since the basis for taxation of pensions has not changed since 2006, is a root and branch review of the system overdue?

The gross cost of income tax and National Insurance pension reliefs in 2020/21 was an astonishing £67.3bn according to official statistics. If the Chancellor did decide that it’s time to update the system, here are some things he might consider:

Lifetime allowance – this is the maximum size to which a pension pot can grow tax-free. Above the cap (currently £1,073,100), tax is payable at 55%. Reducing or freezing the cap would raise more tax but could catch a lot of taxpayers who have been prudently putting money aside so that they do not burden the state in retirement.

Higher rate tax relief – qualifying contributions benefit from tax relief at the individual’s highest tax rate. The cost to the Treasury could be reduced if this was limited to basic rate relief instead. Given that 58% of all relief given was at the higher or additional rates, the savings could be substantial. 

Annual cap – for most people it is possible to make tax-relieved pension contributions of up to £40,000 a year, although this drops to as little as £4,000 for high earners. Reducing the cap would reduce the cost of relief. 

Changes to tax reliefs or contribution caps – this could appear attractive to a Chancellor looking to raise large amounts of tax in a hurry. However, such changes would be very short-sighted: reducing tax relief on pension contributions makes it likely that fewer contributions will be paid. This means smaller pension pots, and more reliance on state support later.

Tax-free pension withdrawal – currently 25% of a pension can be taken tax-free. Reducing this percentage would increase pension tax receipts, but there’s a catch – any benefit is likely to take longer to be seen, and the change would represent an immediate extra tax charge on pensioners.

We already know that there are going to be a lot of tough tax decisions made in the coming days and months, and the current tax cost of pension contributions must make this a prime area for reform. However, this is an area where short-term gains can create much larger long-term losses, and the Chancellor needs to proceed with caution. In the meantime, any taxpayers who have not already maximised their pension contributions should seriously think about doing so now, while relief is still available.