Tom Selby, head of retirement policy at AJ Bell, comments on Kwasi Kwarteng’s dramatic changes to income tax rates in the UK.
He said: “Chancellor Kwasi Kwarteng’s decision to lower the income tax rates paid by basic and additional-rate taxpayers is clearly intended first-and-foremost to allow people to keep more of their pay and help spur the economy into life. However, both will also have a knock-on impact on retirement saving incentives when people pay into a pension.
“Because pension tax relief is paid at your marginal rate of income tax, lowering the tax people pay also reduces the amount of tax relief they are entitled to.
“For basic-rate taxpayers, lowering income tax from 20% to 19% will cut the effective pension saving ‘bonus’ provided by tax relief from 25% to around 23%. For additional-rate taxpayers, reducing the income tax rate from 45% to 40% will see their savings bonus drop from around 82% to 66%.
“Pensions of course remain extremely tax-efficient long-term savings products for people of all income levels. For basic-rate taxpayers saving outside of automatic enrolment, the reduction in tax relief to 19% will however mean that Lifetime ISAs, which continue to offer a savings bonus equivalent to 20% tax relief, will become comparatively more attractive.
“One other important thing to note is the transitional period afforded certain types of pension scheme. For basic-rate taxpayers saving in ‘relief at source’ schemes – where basic-rate tax relief tax relief is added automatically – there will be an extra year during which they can continue to receive tax relief at 20%. Those in ‘net pay’ schemes, meanwhile – where contributions come straight from pre-tax pay – will presumably receive 19% tax relief from April 2023 onwards.”
How the current system works*
- Basic-rate taxpayer – pays in £80, gets £100 in their pension (20% tax relief, 25% bonus)
- Higher-rate taxpayer – pays in £80, gets £100 in their pension, claims back £20 (40% relief, 66% bonus)
- Additional-rate taxpayer – pays in £80, gets £100 in their pension, claims back £25 (45% relief, 82% bonus)
Under new tax rates – once fully implemented*
- Basic-rate taxpayer – pays in £81, gets £100 in their pension (19% tax relief, 23% bonus)
- Higher-rate taxpayer – pays in £81, gets £100 in their pension, claims back £21 (40% relief, 66% bonus)
- Additional-rate taxpayer – pays in £81, gets £100 in their pension, claims back £21 (40% relief, 66% bonus)