The case for restricting up-front relief on income tax for pension contributions is “weak”, the Institute for Fiscal Studies has said. Instead, it proposes to levy national insurance on employer contributions, reduce tax free cash and bring defined contribution pots into scope for inheritance tax. 

The IFS on Wednesday published a briefing paper about pensions taxation, saying a change to flat-rate pensions tax relief would be “damaging, complex and inequitable”.  

“Tax reliefs for private pensions are overly generous to those with large pensions and are in need of reform,” said David Sturrock, senior IFS research economist. “The case for restricting up-front income tax relief is weak, however.”  

Sturrock said reducing the cap on the amount that can be taken tax-free from a pension – to £100,000 for example – and bringing pension pots into the scope of inheritance tax would be a better way to reform pensions tax. He also argued the complete exemption of employer pension contributions from national insurance contributions was “a large, opaque and poorly targeted subsidy that should be curtailed”.   

Mubin Haq, chief executive of the abrdn Financial Fairness Trust, which sponsors the IFS Pensions Review of which the paper is part, said too many pension tax reliefs are overly generous to those with the largest pension pots and the highest incomes.   

“These reliefs are ripe for reform and would fit with the PM’s recent pledge that those with the broadest shoulders should bear the heavier burden. Changes to taxation are critical if we are to avoid deep cuts to our public services,” Haq added. 

Any changes to pensions taxation should be “carefully thought through” and set out as a long-term strategy for reform as savers need certainty and stability, the institute said.  

The industry is anticipating that the new government could be looking to increase tax revenue from pensions, having ruled out increases to income tax, national insurance and VAT on ‘working people’. Speculation that chancellor Rachel Reeves could look to replace the current system of pensions tax relief, at the marginal rate of income tax, with a flat-rate relief is rife, and was stoked by the Pensions and Lifetime Savings Association when it announced an upcoming speech by pensions minister Emma Reynolds saying she will discuss a change to pensions tax relief.  

However, some have suggested that the impact on high earners in the public sector makes flat-rate relief unlikely, as the government would probably prefer to avoid a backlash from doctors in particular.
   

 

Instead, the IFS proposes limiting tax-free cash from a pension to £100,000, and “going further, we propose providing the equivalent of a capped 25% tax-free component for basic-rate taxpayers but designed in a way that increases the after-tax value of everyone’s pension (up to the cap) by the same proportion – basic-rate, higher-rate and non-taxpayers alike”, it said, saying a 6.25% taxable top-up on all pension withdrawals would achieve this, with potentially bigger top-ups on withdrawals made via an annuity.  

It also recommends bringing DC pots, currently tax exempt on saving, exempt on investment growth and exempt on death, into scope for inheritance tax could be one way for the government to raise revenues without upsetting its relationship with public sector workers.   

Whether the government will start to levy NICs on employer contributions, also currently EEE, is a bigger question. Given its stated focus on growth, and efforts to project the UK to the world as a business-friendly jurisdiction, this would arguably be the more surprising move.  

The IFS recommends introducing a new subsidy on all employer pension contributions if employer NICs relief is abolished, a proposal it first made in February 2023. 

If employer NICs at the rate of 13.8% were levied while employer contributions attract a 10% subsidy, this would raise about £4.5bn for the exchequer, the IFS said.