Chancellor could plunder tax cuts on pension savings of 6 million higher earners, warns Steve Webb

By Liam On Aug 28, 2024

By David Churchill and Simon Lambert

Updated: 12:38 EDT, August 28, 2024

Rachel Reeves is eyeing an attack on the pension savings accounts of up to six million higher earners after figures showed the cost of tax cuts has soared.

Analysis ahead of Keir Starmer’s dour speech on the economy found the net cost of pension tax cuts rose by £1.1bn on the previous year to £48.7bn in 2022/23.

About 55 per cent of the relief related to high-income earners with salaries between £50,271 and £125,140, and a further 7 per cent to higher-income earners with salaries of £125,140 or more.

Sir Steve Webb, pensions columnist for This is Money and a former pensions minister, said the figures show why the Chancellor is likely to tap into the pension savings accounts of higher earners at her first budget on October 30.

Senior civil servants, such as NHS doctors, senior teachers and civil servants, could be among the group of taxpayers hardest hit by the raid.

The figures, which show more workers will face higher tax rates, were released before the Prime Minister warned of short-term problems in the upcoming Budget.

Keir Starmer was seen as laying the groundwork for tax rises. And with Labour pledging not to raise income tax, national insurance, VAT or corporation tax rates, it is likely that other ways of raising revenue will be addressed.

However, experts warn that changing tax breaks for pensions would be complicated, could hamper retirement savings and hit younger workers’ savings accounts harder in the long run.

High-tax taxpayers hit by such an attack on their pension pots could include senior public sector workers such as doctors in the NHS, senior teachers and civil servants.

Sir Steve, now a partner at pensions consultancy LCP, which carried out the analysis, said: ‘There is no doubt that the Chancellor will be keeping an eye on the high costs associated with cutting tax on pension contributions.’

Ms Reeves is expected to consider a proposal from Treasury officials for a flat 30 per cent rate for pension tax relief.

The Treasury has long wanted to raise taxes on pension savings to raise much-needed revenue, but successive finance ministers have rejected the plan.

Ms Reeves is also expected to look at increases in inheritance tax and capital gains tax to plug the £22bn “black hole” in the public finances she says has been left by the Tories.

Tom Selby, director of public policy at AJ Bell, said there had been much speculation about higher pension rates before the Budget, but the introduction of a lower flat rate could cause major problems, particularly in the public sector.

He said: ‘At the extreme end of the scale, this measure could see everyone’s pension tax relief capped at the basic rate of 20 per cent, with proponents claiming this could generate billions of pounds of extra revenue for the Treasury.

‘But as with most radical changes to pension tax, introducing a flat rate of relief is much easier said than done. Much of the potential savings to the Treasury from a pension tax cut would come from defined benefit schemes, the majority of which are now in the public sector.

‘If a flat rate of less than 40 per cent of pension tax relief were to be applied to these schemes, the only way to ensure that the right level of tax relief was applied to contributions from higher or additional rate taxpayers would be to hit those members with a tax charge that would likely run into thousands of pounds.

‘This would therefore risk creating a major conflict with NHS staff and civil servants, at a time when many public services are already being stretched to the limit.’

Pension tax deduction – is it a risk?

This is a money analysis: Thanks to the pension tax deduction, you actually get back all the tax you would have paid on your contributions. This brings you back to the old level.

It supports the age-old principle of saving for a pension from tax-free income, which has been enjoyed for generations.

Income from pension funds is taxed when it is withdrawn during your retirement.

Tax cuts are also seen as an important incentive to save money for your retirement.

This is something that has become more important as employers have moved from defined benefit pension schemes, where they bear the responsibility for retirement income, to defined contribution pension schemes, where employees are required to build up a pension pot and use this to fund their retirement.

> How pensions work: your essential guide to retirement savings

The tax deduction that supplements the pension pot is based on the income tax rates of 20 percent, 40 percent or 45 percent.

Normally, 25 per cent is automatically added to pension contributions to bring savers back to their pre-basic rate level. This reduces the £80 after tax they put in to the £100 they earned before the 20 per cent tax.

People with higher incomes can then claim back 40 or 45 percent tax on their contributions above these income thresholds.

This seems to tilt the system in favor of the higher paid, because they get more tax deductions, but this is simply because they pay a higher tax rate in the first place.

An alternative system is the workplace salary surrender pension, where employees benefit from all the tax advantages because they exchange their income for an additional amount that their employer pays into their pension before tax.

The freeze on tax thresholds has pushed more workers into the higher 40% tax bracket, into the 60% tax trap as the personal exemption above £100,000 is abolished, and into the 45% tax bracket which now kicks in at £125,140.

This has given the government more tax revenue, but has subsequently increased the cost of pension tax cuts, as more is paid out at higher rates. However, the amount the Treasury earns from this tax burden far outweighs the additional cost of tax cuts.

Rachel Reeves is rumoured to be considering cutting tax breaks for pensions, but this would be highly controversial and create further generational inequality as younger workers lose the savings advantage that older generations enjoyed.

Moreover, it would be very complicated and would pose problems for defined benefit pension schemes, of which there are many in the public sector at present, and for salary sacrifice pension schemes.

> What influence does a flat-rate pension deduction have on salary sacrifice schemes?

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Chancellor could plunder tax cuts on pension savings of 6 million higher earners, warns Steve Webb

Pension tax deduction – is it a risk?