The Chancellor’s maiden solo budget contained an announcement that could have a radical impact on the way pension savings are taxed. George Osborne’s Green Paper invites interested parties to comment on potential wholesale changes in the taxation of the pension pots of individuals.

EET

The Government’s method of incentivising pension saving under the current system is through an exempt-exempt-taxed (EET) system.

Under this regime an individual’s pension contributions, and the contributions made by their employer on their behalf, are exempt from income tax, with employer contributions also being exempt from National Insurance Contributions (subject to both an annual and lifetime allowance for each individual).

Further, any yields from the investment growth of the pension contributions are also exempt from personal tax while they remain in accumulation (again subject to a lifetime allowance).

Taxation occurs at the point when the pension becomes payable to the retiring individual with rates set in line with the retirees marginal income tax rate, although up to 25% of each person’s pension pot can be withdrawn as a tax-free lump sum.

The official line is that the Government is seeking to implement a simple and transparent system for taxation of pension savings that is sustainable in the long term.

The Green Paper talks of allowing individuals to take personal responsibility for ensuring they have saved adequately for what is becoming statistically an increasingly lengthy period of retirement.

However, the Government has also published figures that in 2013-14 it forwent nearly £50 billion in tax income under the EET system. In particular employer contributions have seen a significant increase as employers look to finance large deficits in defined benefits schemes. Additionally, a large majority – approximately 2/3rds – of the benefit of pensions tax relief is felt by those in the higher and additional tax rate brackets.

While the gradual reduction of the lifetime and annual allowances, coupled with the introduction of a new regime of tapered tax relief from April 2016, is projected to save approximately £6 billion per year and will significantly reduce the proportion of relief attributable to the country’s top earners, the Government is clearly intent on doing more in respect of these two areas.

TEE

Despite taking care to make it clear that he was not attempting to ‘pre-judge’ the outcome, Osborne, both in person and through the Green Paper, has suggested one such avenue for fundamental reform would be to set up a system of pension taxation equivalent to that which is currently in place for ISAs.

Such a system, unlike EETs, would ensure that pension funds would be made up of already taxed income, which is then topped up by the government in a way that is similar to the tax relief provided now.

Then when it came to an individual’s retirement the income would be tax-free, much as it is in relation to funds held in an ISA.

This is known as a Taxed-Exempt-Exempt system (TEE).

Responses required

The Green Paper seeks responses on the following questions:

  • Does the complexity of the current system of pensions tax relief undermine the incentive to save?
  • Would an alternative system result in greater engagement with pension saving?
  • Should different treatment be afforded to DB and DC pensions respectively?
  • What administrative barriers exist to reform, particularly in the context of auto-enrolment?
  • How should employer pension contributions be treated?
  • How can the government ensure the system is sustainable in the long term?

The consultation will run until 30 September 2015, after which the government will publish the results, and with them a White Paper in which it will make its recommendations.