Reform of pension tax relief

Overview of pensions and taxes

Broadly, tax relief on pensions is intended to encourage private saving for later life.

The Library briefing Pensions Tax gives an overview of pensions taxation in the UK. HMRC’s Pensions Tax Manual has much more detailed information.

The Library briefing Direct taxes: rates and allowances for 2024/25 outlines the direct tax rates and principal tax allowances in the UK. More detail on tax rates and allowances for the 2024/25 year are set out in Annex A to HM Revenue & Customs, Overview of Tax Legislation and Rates.

Options to reform pensions tax

Flat rate pensions tax relief

Pension savers do not pay income tax on contributions to pension schemes, up to set limits. Instead, they receive income tax relief at their marginal rate of income tax – the rate they would have paid if they had not contributed to a pension.

One option for reform is a single rate of tax relief, rather than relief being given at someone’s marginal rate of income tax. Supporters often argue that it would be fairer for all taxpayers to receive the same rate of relief.

Others argue that a single rate of tax relief, unless accompanied by further measures, could mean “double taxation” for higher rate taxpayers. They would pay tax on the difference between their marginal rate of income tax and the flat rate of tax when making contributions, and again pay income tax when those savings are withdrawn as a pension.

Taxing pension contributions and top up payments

In the UK, private pension saving incurs income tax on an “exempt, exempt, taxed” model (EET) for income tax. Contributions and investment growth are exempt from income tax, but it is paid when savings are used to make pension payments. A different approach which has been considered is a “taxed, exempt, exempt” model (TEE). In this system pension contributions incur income tax like other earnings, but investment growth and withdrawals would be exempt.

Tax free lump sums

People can receive up to 25% of their pension as a tax-free lump sum. The standard maximum tax-free lump sum is £268,275. It has been argued that lowering the maximum amount, for example to £100,000, would increase tax revenue without affecting most pension savers.

Inheriting pensions

If someone dies before their 75^th birthday most lump sums paid from their pension are tax-free up to a limit. If someone dies after their 75^th birthday, the person receiving a lump sum pays income tax like they would on other income. There have been calls to end this difference.

Pension assets are currently generally exempt from inheritance tax, and some organisations had proposed that this exemption should end. At the Autumn Budget 2024, the government announced that from 6 April 2027 most pension funds and pension death benefits will fall within someone’s estate and will be considered when calculating inheritance tax.

Employer National Insurance Contributions (NICS)

Employers do not pay NICs on pension contributions, but employees and self-employed people do. Some employers offer salary sacrifice pension schemes to make tax-efficient use of this difference.

There have been proposals for employer NICS to apply on their contributions. There have also been suggestions that such a proposal could allow NICs relief on pension contributions made by employees.

The Association of British Insurers cautioned that this could lead to employers making lower pension contributions.

Self-employed

Eligible employees are automatically enrolled into a pension scheme by their employer. Self-employed people are not.

In September 2022, the Work and Pensions Select Committee proposed that the government consult on changes to National Insurance paid by the self-employed (Class 4) to increase the proportion of self-employed people saving into a pension.