Major pension changes could see pensions taxed like ISAs

The tax treatment of pensions has been a talking point amid consideration of further pension changes. In the Summer Budget, Chancellor George Osborne announced a consultation to discuss remodelling the current tax system, suggesting that pensions could become more like ISAs.  

Tax advantages of pensions, such as tax relief, mean the current system is an expense to taxpayers. Under existing rules, savers receive tax relief on contributions and withdrawals are taxable, which can leave them with a large bill to pay if they take a large amount of money in one tax year.  

Pensions could become more like ISAs

One potential change is taxing pensions in a similar way to ISAs, with contributions made from taxed earnings, then both growth and withdrawals being tax free. Such a shift would mean that savers would no longer benefit from tax relief on contributions and the compound interest that is gained on top of it, potentially reducing the total sum at retirement.

Some may also be worried that allowing people to withdraw their entire pension tax-free from the age of 55 would remove a barrier that currently makes savers think twice before emptying their entire pot.

Former pensions minister Steve Webb said that ‘Pension ISAs’ would be a disaster – ‘I once said pensioners would be free to spend their funds on Lamborghinis if they wanted to, but actually the tax they have to pay stops them.’

However, people were worried that the new pension rules introduced in April would trigger a spending frenzy and see people cash in irresponsibly, yet most savers have been sensible with their pensions since the new rules took effect*. ‘Pension ISAs’ would make it easier for people to splash out on luxuries at the expense of their retirement income, but once again this may not be the case.  

One concern is that an ISA-style taxation on pensions could undermine long-term saving objectives, such as auto-enrolment into workplace pensions. Since it was first introduced, auto-enrolment has seen the amount of money saved into a UK pension steadily increase: between 2013 and 2014 savings increased by £2.6 billion.

However, the flexibility of ‘pension ISAs’ could reverse the progress that has been made; removing tax relief would leave little incentive to save via a pension rather than an ISA or a regular savings account, especially as the money is inaccessible until the age of 55.

Flat-rate tax relief is an alternative option

Another suggested pension change is to keep tax relief on contributions but make it a flat rate of around 30%. This could make the system a lot more straightforward and encourage pension saving among basic-rate tax payers. Higher-rate tax payers would be at a disadvantage and receive less than they do currently, although there would still be a significant incentive.

Pensions have had a lot of positive coverage in the past 18 months, however too much reform may cause confusion and deter people from saving. It may also undermine the confidence that their pension will be left alone. Isa-style pensions are likely to have a lot of complexities to work out, whereas a flat-rate tax relief could be much simpler and easier to understand. It would also provide an immediate benefit to savers in the form of upfront tax relief. However, rather than continuous reform, a sustained effort to educate people on the benefits of pensions and the importance of saving for the future is important.

Would you like to see further pension changes? Let us know with a comment below.

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Important Information

Tax treatment depends on your individual circumstances and may be subject to change in future.

*http://www.theguardian.com/money/2015/oct/05/pension-freedoms-under-65s-cashing-in-abi

The details provided in this article are for general information only and are in no way deemed to be financial advice. All of the material is correct as of the publication date, but could be out-of-date by the time you read the article. For our latest information and news, please see our articles section: https://www.portafina.co.uk/whats-new

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