100 years of pension tax relief as flat rate speculation grows

As pension tax relief celebrates its 100th birthday this year, new analysis by insurer Aegon highlights the value of pension tax relief, which can be worth hundreds of thousands of pounds to regular savers during their working lifetimes.

With tax relief on pension contributions under threat of government reform, potentially limiting its value, there could be significant winners and losers.

The analysis found that an individual who starts by contributing £100 a month to their pension from age 22, out of take-home pay, and who increases that contribution in line with earnings growth of 3%, could have a pension pot worth £354,600 at state pension age.

Of this pension pot, £70,900 or 20% of the total is the result of pension tax relief, the top-up added by the government.

These figures don’t consider any employer pension contributions the individual might also receive.

As things stand, basic rate taxpayers get tax relief of 20% on their pension contributions, which means a contribution of 4% from their take-home pay is increased to 5%.

Higher rate taxpayers receive an even more generous tax relief on their pension contributions, at 40%.

Someone who started saving £300 from take-home pay from age 30 could have a pension pot of £877,900 at age 68. Of this, £351,100 or 40% is from the higher rate tax relief they currently receive.

Pension tax relief was first introduced in the Finance Act 1921. Despite a 100-year history, it remains one of the least well-understood savings incentives.

But with a Budget coming up next month and years of intense speculation around cuts to tax relief, the Chancellor might introduce a flat rate of between 20% and 30%.

If a flat rate of pension tax relief is introduced, higher rate taxpayers will lose out, but basic rate taxpayers could receive a more generous top-up.

Aegon crunched the numbers again for higher rate taxpayers, assuming a tax relief flat-rate introduced at 30%, reducing the eventual pension fund from £877,900 to £752,400 at state pension age, losing £125,400.

To maintain the same size of the projected pension pot, the starting contribution would need to increase from £300 to £350 a month.

Conversely, a basic rate taxpayer would benefit from a flat rate of pension tax relief at 30%, seeing their eventual pension pot rise from £354,600 to £405,200 at state pension age.

Steven Cameron, Pensions Director at Aegon, said:

“Pensions are a very attractive way to save over the long-term in part due to the top up the government provides through tax relief. For a basic rate taxpayer, a £100 pound contribution from take home pay is currently boosted to £125 after tax relief. And a £300 per month contribution from take home pay for a higher rate taxpayer is boosted to £500. Over the years the value of the tax relief element of pensions contributions is worth tens of thousands of pounds, even to those on modest incomes.

“If pension tax relief is reformed it will represent a major change to the current system after 100 years and there will be significant winners and losers if, as has been trailed, a flat rate is introduced somewhere between 20% and 30%. For higher rate taxpayers this would mean having to make additional pension contributions to offset the reduction, while basic rate taxpayers would experience an uplift to their pensions.

“For a basic taxpayer, an increase in pensions tax relief from 20% to 30% will mean their monthly pension contribution of £100 from take home pay is boosted by £18 a month. Over the course of a working life, this could mean an individual builds an additional £50,600 into their pension fund. This assumes contributions rise annually by 3% and investments grow at 4.25%.”