4th June 2014
Will Chancellor George Osborne risk the wrath of Middle Britain by scrapping the tax free lump sum option on retirement in the 2015 Budget – just weeks ahead of the election? Investment journalist Tony Levene thinks not.
Will he jeopardise both the political popularity and the implementation timetable of his “no more annuities” move in the last budget to close a potential tax loophole?
And will he upset the entire pensions apple cart by ditching an incentive to keep saving for retirement?
If you believe the answer to these is “yes”, putting forward abolishing the 25 per cent tax free lump sum makes sense. But if you consider George Osborne to be the consummate political operator – pensions freedom more than made up for now forgotten taxes on pasties, caravans and grannies – then ignore the suggestion.
Osborne’s officials will have told him of the Middle England furore the last time a Conservative chancellor thought about ending tax free lump sums, back in 1985 when he was still in short trousers. (And it has certainly not be mentioned in today’s Queen’s speech).
Axing one tax relief gains £24bn
The idea behind the abolition concept, first floated as a possibility in trade magazine Corporate Adviser and then the Telegraph Group newpapers, is that taxing the first 25 per cent of the pension pot – currently tax free – on the same basis as the other 75 per cent would save the exchequer £24bn a year.
The tax loophole, which is clearly concerning civil servants, is that someone aged 55 or over in employment could “sacrifice” all of their salary bar the minimum wage element – around £12,500 for a full time person – to their employer who would then pay it into a pension plan. Contributions to pension schemes are free of income tax and both employer and employee national insurance.
Someone earning £37,500 would give up £25,000 so only pay tax and national insurance on £12,500. The £25,000 would go into a scheme from which tax free withdrawals could be effected immediately. These sums would restore the spending power lost through the salary sacrifice.
Taking the maths a stage further (but ignoring charges), the first £6,250 would be income tax free while further withdrawals up to £25,000 would be taxed at 20 per cent (the same as the income would have been without the salary sacrifice). The big difference is that the Treasury has lost national insurance from both employer and employee.
This will only become widely possible from next April when pensions liberalisation allowing everyone to take their money as they choose comes into force. It has been a potential strategy for those in flexible drawdown schemes for some time.
How significant is this?
The £24bn figure is a calculation assuming everyone in the eligible age group takes advantage of this loophole either to the maximum of their wage packet or up to the £40,000 annual pensions contribution limit. It will make some but not a lot of difference to the very highly paid so the real targets for this loophole are those on around £35,000 to £85,000 a year.
While this strategy has some appeal to tax planners, in the real world, traction is less likely. The Revenue will look askance at someone whose taxable salary suddenly drops dramatically. If Ms A earns £60,000 one year but then drops to £20,000 while continuing the same work over the same hours, there would be a probe. This could look like an avoidance plan – especially if it suddenly applies the day she reaches 55.
A second problem is a firm’s internal personnel requirements. Suppose Ms A had a stated £20,000 salary while Mr B who does exactly the same job, but who is 50, continues to earn £60,000. There could be issues of ageism, sexism and other comparability parameters to confront. And there would be problems if Ms A was made redundant as her payoff would be based on £20,000 rather than £60,000. This could be important were she to carry on working – perhaps to the state retirement age some ten years in the future.
One suggestion from unnamed “experts” it would even be worthwhile for those aged 50 to 55 to salary sacrifice while taking out a mortgage to pay for their living expenses. That way, they could establish the pension scheme well before they reach 55. But this ignores that mortgage lending affordability criteria have been substantially tightened. Our Mr B might get a £200,000 loan on his original salary but would do well to get anything much on £20,000.
A dramatic salary fall would also damage someone’s rating if they applied for a new credit card or personal loan.
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Who floated this idea?
The abolish the tax free lump sum story is predicated on preventing a £24bn tax leakage. But this assumes everyone does this to the maximum. “There is a current consultation on the coming liberalisation issue which closes soon. But this idea does not seem to have arisen from any mainstream firm. And there are electoral implications. All we have been told is that the Treasury has been told,” says pensions guru Laith Khalaf at pensions firm Hargreaves Lansdown.
Abolishing the tax free lump sum does not benefit employers as the logistics (see above) are substantial. Putting this forward does not benefit pension fund managers or life company retirement schemes as withdrawing the tax free element would cut sales and reduce auto enrolment numbers. Life companies were a big force in getting the idea shelved three decades ago. And it does not benefit the government which will have to explain why the Chancellor said his big reform would not affect the tax free lump sum or why the Treasury has continually denied it wishes to deal with this very hot potato.
That leaves annuity providers as a possible suspect. Their business has slumped by up to a half since pensions freedom was announced. Many of those who have held off will have done so to ensure they get to consider anything new in pension income provision that might emerge over the coming year. They would love to get their hands on the entire pension pot in one way or another rather than 75 per cent.
Alternatively, the Government might have put it forward to test reaction but the last time this was discussed was when the Government was supposedly looking to close down the tax benefits of ISAs because of a growing number of ISA millionaires. The subsequent Budget saw the tax breaks on ISAs increased substantially.
Where does this go now?
While everyone stresses that you should never say never, if avoidance legislation and personnel factors are not enough, one suggestion would be to limit the number of times that an individual can take a tax-free lump sum – perhaps to once (as with some drawdown strategies) or once every ten years. A second would be to limit the total tax free amount to, say, £50,000. This would only affect a minority of well off pensioners though they would tend to be Conservative supporters of course.
In any case, liberalisation does not affect the total tax take. If someone earns £10,000 a year from an annuity, they will pay the same income tax as if they withdrew £10,000 a year from their pension pot. And while very few will blow their pensions on a top of the range Lamborghini (they would pay 45 per cent tax on most of that), more spending boosts VAT returns and improves the economy.
The avoidance would be in national insurance – a tax that pulls in more than VAT and which is now so riddled with anomalies that governments keep talking about rolling it up into income tax. So far, all they have done is talk.
“Less has changed than people think,” says Khalaf. “People don’t like annuities but the fundamentals of providing for a long retirement life remain. There is no magic wand. There may be new products but they will be unproven and, if the past history of guaranteed short life annuities is any guide, they will be pricey. Paying three per cent of your pension pot each year for a guarantee is expensive – and you may not be any better off than with a conventional annuity.”
He adds: “You can’t ignore the electoral cycle. Labour and the Liberal Democrats will both favour limiting tax relief on contributions to the basic rate or perhaps 30 per cent later this year. So there could be a review on tax relief by autumn 2015. The trouble is there is no consensus. And you have to give the current reforms time to bed down. Knee-jerk solutions rarely work.”
Further reading: Some industry experts do see a risk. Jelf’s Steve Herbert and Mindful Money contributor says that rather than being set free it may be a case of pensions on parole.
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