Taxation of private pensions

Taxation of private pensionsCarl Emmerson

© Institute for Fiscal Studies

How should pensions be taxed?


When contributionsare made

When returnsaccrue

When incomeenjoyed

Taxing pension saving (TTE)



When returnsaccrue

When incomeenjoyed

Taxed Taxed ExemptTax on normal returns distorts towards spending rather than savingDoesn’t allow those whose tax rate drops at retirement to smooth their tax-rate

Income tax & capital gains tax treatment of deposit accounts

Taxing pension saving (EET)



When returnsaccrue

When incomeenjoyed

Exempt Exempt TaxedNormal returns untaxed but above normal returns taxedThose whose tax rate drops at retirement can benefit from tax-rate smoothing

Income tax & capital gains tax treatment of private pensions (broadly)

How does UK practice depart from EET• Annual and lifetime limits on how much can be saved in

a tax-advantaged private pension

• One quarter of a private pension can be drawn as a lump sum free of income tax

• Employer contributions – roughly three-quarters of the total – escape National Insurance Contributions (NICs) entirely– largest component of remuneration on which NICs are not

paid

• Corporation tax and stamp duties are levied as some returns accrue


What is the cost of pension tax relief?• Need to compare tax payments by individuals under the

current system to what it would be under a sensible alternative

• HMRC says £38.3 billion in 2011–12 from considering income tax and NICs and comparing current system to a TTE system– revenue forgone from up-front relief for current workers less

income tax paid by current pensioners• But the HMRC calculation is unhelpful because:

– TTE is not a sensible alternative as the normal rate of return should be untaxed and, arguably, individuals should be able to tax rate smooth

– changing demographics and rising real incomes mean that today’s pensioners will in aggregate pay less income tax than future retirees

• Better estimate is less than half the HMRC estimate– NICs relief (£15 billion) + tax-free lump sum (perhaps £2.5

billion) – but this still ignores any impact of corporation tax and

stamp duties on returns


Who benefits from pension tax relief?• Need to compare tax payments by individuals under the

current system to what it would be under a sensible alternative

• HMRC says that those on higher current incomes benefit disproportionately from up-front relief– for example in 2010–11 the richest 1% made 16% of

contributions but HMRC estimate they received 22% of up-front relief

– (big caveat is that this estimate ignores employer contributions)

• But– ignores the fact that rich will pay disproportionately more

tax in retirement– given the top 1% paid 24% of all income tax revenue

perhaps not surprising or, necessarily, unfair


Reduce up-front income tax relief?• Reduce annual allowance or lifetime contribution limit

– £255,000 per year and £1.8 million in 2010–11, cut by the coalition government to £40,000 and £1.25 million from April 2014

• Restrict up-front relief to the basic rate of income tax– proposed by the Liberal Democrats at the last general

election• Either could raise significant sums with the better off

losing more• But more general reductions would come at cost of

– moving further away from benchmark EET and therefore distorting saving behaviour and restricting opportunities for tax rate smoothing

– considerable complexity as valuing pension contributions in defined benefit pensions far from straightforward

• Much better reform options exist© Institute for Fiscal Studies

Cut the tax-free lump sum?• 25% of a private pension can be taken as a lump sum

entirely free of income tax– extremely generous EEE income tax treatment for up to

£312,500 of pension saving• Not well targeted at encouraging saving among those

who might otherwise end up on a relatively low retirement income– more generous to those who pay higher rate income tax in

retirement than those who pay basic rate tax– should those who have already squirreled away £1m in a

private pension be subsidised to save more?– encourages a lump sum rather than a retirement income

• An alternative would be to top up annuity purchases up to a limit– would subsidise retirement incomes rather than lump sums – would be worth less rather than more to those paying

higher rate tax in retirement© Institute for Fiscal Studies

Reduce generosity of NICs treatment?• Roughly three-quarters of pension contributions made on

individuals behalf by their employers– these escape NICs entirely: no employer or employee NICs on

either contributions or pension income• It would be straightforward to impose employer NICs on

employer contributions– would raise an estimated £10.8 billion– but would be a move towards TEE rather than EET treatment

• Alternative would be to charge NICs on pension income– every 1ppt of NICs charged would raise £350 million– could start low and increase gradually over time– would involve some retrospective taxation but arguably the

shift from income tax to NICs over the last 30 years has unintendedly led to working age earnings being taxed relatively more heavily than retirement incomes


Credits for corporation tax? Exemption from stamp duties?• Currently returns in pensions are not subject to income

tax or capital gains tax• But these returns may be reduced by

– corporation tax– stamp duties on share transactions and property purchases

• Ideally corporation tax and stamp duties would be reformed

• Absent this there is potentially a case for crediting returns accrued in private pension to offset the impact of these taxes– would be a move in the opposite direction to that made by

Norman Lamont in 1993 and Gordon Brown in 1997


Conclusions• It is not possible to raise lots of revenue through a

harmless reduction in up-front income tax relief on pension saving

• Better ways of raising revenue and improving the pensions tax regime exist

• Why allow up to £312,500 to be saved in a private pension entirely free of income tax?

• Don’t forget NICs: three quarters of pension contributions escape NICs entirely and this is excessively generous


The IFS Green Budget 2014


5 February 2014, Beveridge Hall, Senate House, Londonwww.ifs.org.uk @TheIFS

Real household disposable income


1971.0

1972.0

1973.0

1974.0

1975.0

1976.0

1977.0

1978.0

1979.0

1980.0

1981.0

1982.0

1983.0

1984.0

1985.0

1986.0

1987.0

1988.0

1989.0

1990.0

1991.0

1992.0

1993.0

1994.0

1995.0

1996.0

1997.0

1998.0

1999.0

2000.0

2001.0

2002.0

2003.0

2004.0

2005.0

2006.0

2007.0

2008.0

2009.0

2010.0

2011.0

2012.0

2013.0

2014.0

2015.0

2016.0

2017.0

2018.0

100

150

200

250

300

Per-

capi

ta R

HD

I (in

dexe

d to

197

1 =

100

)

Mid-70s Recession

Early 80s Recession

Early 90s Recession

What about (re)introducing the 10p rate?

0 2.5 5 7.5 1012.5 1517

.5 2022.5 2527

.5 3032.5 3537

.5 400

100020003000400050006000 £12.5k personal allowance (£12bn)

10% band from £10k to £15k (£12bn)

Annual taxable income (£1000s)

Inco

me

tax

liabi

lity

(£)


• Almost identical impact to increasing the personal allowance

• Hard to think of a good economic rationale for such a policyNotes and sources: see Figure 7.7 in Green Budget document

Documents

Taxation of private pensions