Cut pension tax deals – cut the deficit

15th February 2012

The rumour and the denial machines are moving into top gear. There's a budget due in just over a month's time so the will Osborne won't Osborne story mill is in full flow. Pensions paid to those on higher income tax rates are top of the list for potential pain.

Chief secretary to the Treasury Danny Alexander told The Daily Telegraph that the better-off are "receiving overly-generous tax relief when they invest money for their retirement."

Slashing tax relief on rich people's pensions

He wants tax relief halved from 40 per cent to the basic 20 per cent for higher rate taxpayers – effectively those earning over £42,500 in the tax year starting April 6. He claims this would save £7bn a year and make the system fairer – currently the better off get twice as much tax relief for each pound into a pension than those further down the pay scale. Half of the £7bn goes to those earning more than £100,000 while higher rate taxpayers overall make up about one in seven people but take some four fifths of the tax relief – the wealthier can afford to save more.

The UK system offers tax relief on contributions paid in but taxes pensions (often at a lower rate as income tends to fall in retirement. Other systems offer no tax relief but pay pensions tax-free.

Sacrificing salary sacrifice

The pensions and financial advice worlds have understandably reacted with anger to the Alexander proposal. They claim it would reduce the incentive to save for retirement. It would reduce contributions by their best customers.

But economist and Mindful Money blogger Peter Morgan sees a further potential to reduce the deficit by bringing in more tax revenue. He calculates that banning "salary sacrifice" schemes could save an extra £8bn a year – money that could reduce the deficit.

Here's how it works. The basic idea is to reduce salary for national insurance purposes while maintaining pension contributions and take home pay – there is income tax relief on pension contributions but they are liable to national insurance.

The employee volunteers to take a cut in gross pay. This saves national insurance both for the employee and employer. By computing the figures correctly, the saved national insurance can make up for lost pension payments into a company plan – whether final salary or money purchase –  leaving the employee with exactly the same spendable pay. A number of pensions providers offer calculators, presenting salary sacrifice as a win for the employee and for the employer who pays less national insurance.

Morgan says: "Salary sacrifice pensions have become a popular choice for pension saving. It is well known that paying money into a pension attracts tax relief. However, it is less well known that how that money is paid into your pension scheme matters too."

He gives an example. Assume your salary is £20,000 and you and your firm pay 10% (£2,000) into a pension scheme. Currently you pay national insurance on £20,000 (and income tax relief on £2,000). However, your employer could offer to pay you £18,000 rather than £20,000. This way they and you only pay national insurance on just £18,000 rather than £20,000. The two sides now put in 10% or £1,800. But the national insurance saved more than compensates and allows the employer to put in the missing £200 – and potentially make a saving as well.

Morgan says: "The costs of salary sacrifice to the Exchequer are obvious. The employee can save up to 11% of earnings and the employer 12.8% of earnings.

Employers can profit from staff sacrifice

" Employers are not, of course, obliged to pay the national insurance contributions savings they make from the scheme into the employees' pensions. Often employers that do make the payments will only pay part of the savings into the employees' pensions with the justification that they are using the rest to cover the cost of running the salary sacrifice scheme."

The scheme is focused on those paying basic rate income tax as they pay a far greater percentage in national insurance compared with those on higher rates.  It's now 12% on the first slice of earnings but only 2% for earnings taxed at higher tax rates – this stops at state pension age. Employers put in 13.8%.   So the direct gain from salary sacrifice is much greater to those on lower earnings, making the concept popular. The gain to the employer is more or less proportionate to an individual's earnings.

But, Morgan says, "although, salary sacrifice is of greater benefit to lower earners, you could argue that it is, in the first place, advantageous only to those who work for the select employers that offer it, thus making it far from egalitarian." Salary sacrifice is mainly aimed by pensions consultants at big employers.

The amount saved by employers by the Treasury not charging national insurance on employer pension contributions is over £8.2 billion per year. This could finance a reduction in the main employer's rate of national insurance of about 2%.

What should the Chancellor do?

The Morgan advice to Osborne? "The government should aim for a simple, flat tax system with few exemptions. Equalising the national insurance treatment of employer and employee contributions would be a step in that direction."


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