A ‘call for evidence’ consultation, recently issued by the government, addresses some key issues highlighted in my last article on pensions tax relief and puts forward four possible remedies. I’m pleased to see this finally happening and equally pleased to say that we’re well ahead of the curve, having solved the conundrum for our clients five years ago…
The key issue
If you put money into a pension, the basic principle is that you get to defer your tax liability until retirement.
For any money you pay into your pension as:
...you are entitled to tax relief at:
If you’re in a murky category somewhere in the middle you’re entitled to 60% relief (a topic for another day).
How do you calculate tax relief for a non-taxpayer paying into a pension? Here’s where things get tricky because the answer depends entirely on the type of pension you’re in, rather than your tax status. This clearly isn’t right but people don’t object because so few are aware of the difference. Such is the complexity of our wonderful pension system.
The root cause: two tax relief systems
Before 1988, only employers or the State could set up and provide pensions. If you were in a workplace pension and made a personal contribution, your employer would divert the money from your pay before tax and send it straight to the pension provider. This system is known, somewhat counterintuitively, as net pay (even though the contribution comes from your gross pay). Remember the term – it is important for the rest of the story.
So far, so good, but in 1988 things turned on their heads with the introduction of personal pensions.
As the name suggests, personal pensions did not need to be set up by employers or the State and so contributions could be paid directly by individuals, rather than through payrolls.
Consequently, a new system of tax relief had to be introduced, as contributions could come from already-taxed pay. This new system adopted the equally confusing name relief at source (or RAS).
Under RAS, pension contributions are assumed to come from already-taxed income. They’re paid net and the pension provider reclaims income tax at the basic rate of 20%. Since approximately 83% of workers are basic rate tax payers, RAS works well for the majority of people. If your marginal tax rate is higher than 20%, you can reclaim the extra, although it is surprising how many people fail to do so.
The non-taxpayer conundrum
So what happens if you earn less than the Personal Allowance (£12,500 in the 2020/21 tax year) and therefore pay no tax in the first place? What tax relief do you receive on your pension contributions? It depends what type of pension you are in:
Net pay pension
Your £100 contribution is deducted from your pre-tax pay. Because you would not have paid tax on this even if you’d taken it as salary, you are no better off having paid this money into your pension. In fact, you could be worse off as the money could be taxed when you withdraw it, depending on your income tax position in retirement.
If you pay the same £100 into a RAS pension as a non-taxpayer, the pension company can still reclaim the 20% tax relief for you. It is a weird little quirk (administrative simplification) of the system and a rare example of HMRC choosing the easy option over additional tax revenue.
The result? Pay in just £80 and HMRC will credit you the £20, just like if you were a basic rate taxpayer. You’ll still have the same £100 in your pension as the net pay pension member, but your contribution will have only cost you £80.
The consultation and the 1.5 million affected
According to the government’s consultation, 1.5 million non-taxpayers are enrolled in net pay pension schemes and are missing out on this valuable pension boost. It is also worth noting that of the 1.5 million people identified, a disproportionately high number are women. Something clearly needs to be done, but what?
Despite thinking about it for a long time (since 1988, presumably) the government is no closer to solving the problem and has thrown it open to a public consultation. The consultation is at pains to point out that the government is not looking for a novel approach. It wants any solution to be straightforward and proportionate.
The consultation also makes clear that it is not seeking to change the basic principle that people should broadly receive tax relief in keeping with their highest marginal tax rate - good news for those fearing a switch to a flat-rate relief system as outlined in my previous piece.
Whilst keen to hear more, there are four possible remedies currently on the table, all with their own pros and cons.
When we launched the Courtiers workplace pension back in 2015, we thought long and hard about this very issue and devised our own approach, which has been working very well ever since.
The Courtiers Group SIPP operates on the basis of RAS but we also allow employees to use salary exchange. Salary exchange means that employee contributions are effectively treated as if they were paid via the net pay system, but with an additional National Insurance saving that the employee can either have as extra take-home pay or an extra boost to the pension. Salary exchange is the default position, but we recommend those with income below the Personal Allowance revert to the RAS basis.
Ours is an elegant solution that solves all of the problems identified above, but with the added advantage that employees and employers benefit from National Insurance savings, all within a single pension.
Who says you can’t have your cake and eat it?
The consultation closes on 13 October 2020. We’ll share our approach and, with any luck, it’ll help the 1.5 million workers currently missing out.
Jonathon Howard APFC, IMC
Head of Corporate Clients
Please note that tax treatment depends on individual circumstances and may be subject to change in the future.
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