Important information - the value of investments and the income from them can go down as well as up, so you may get back less than you invest.

The new Labour government has been busy making sure we all know exactly how tough its first Budget is going to have to be.

A £22bn ‘black hole’ in the nation’s finances has been identified and a combination of tax rises and spending cuts is going to have to fill it, the government has said, while also warning that those with the ‘broadest shoulders should bear the heavier burden’.

The rumour mill is now in overdrive trying to identify the areas the government will target to raise money when it announces its first Budget on 30 October. The long-term savings regime is one of them, and the system for pensions in particular.

Here’s a look at some of the most talked about reforms, and whether they could actually happen. Note - these are not planned changes but merely possible reforms that have been discussed within the savings industry. They should not be taken as the basis for any financial decisions.

Tax relief on pensions

Money contributed to a pension can benefit from tax relief. Basic rate tax relief is added automatically, meaning an £80 contribution becomes £100 inside a pension, while extra relief is available for higher and additional rate taxpayers which can be claimed back through their tax return. Income Tax then potentially applies on withdrawals.

It means the biggest benefits are often available to those earning at higher levels and then withdrawing at lower ones.

There has long been talk that the system could be changed to target the benefits of tax relief more to those on lower earnings. Previously Rachel Reeves, the Chancellor of the Exchequer, has argued in favour of a flat rate of 33% relief for everyone.

Labour has insisted that this is not its policy, and no longer Reeves’ view. Any change risks being unpopular and could be very difficult to implement, not least because it could create a system where tax on withdrawals is at a higher rate than the relief on contributions - destroying the incentive to save into a pension at all for some people.

It’s a point made in analysis published this week by the Institute for Fiscal Studies, which said: ‘Tempting as it may be, there is no coherent logic to making relief on contributions flat-rate while continuing to tax pension income at the individual’s marginal rate.’1

A change in this area could happen, of course, but the complexity and difficulty of doing so make it unlikely.

Tax-free cash

As much as 25% of pension money can be accessed without tax to pay, up to a limit of £268,275. This ‘tax-free cash’ - or Pension Commencement Lump Sum in the official jargon - is one of the most popular aspects of the pension system and one of the key reasons why saving within a pension is advantageous from a tax point of view.

There was controversy during the election campaign when Sir Keir Starmer was asked about the future of tax-free cash and replied that the current system would be reviewed in the coming years. Labour spokespeople had to quickly confirm that he had spoken in error, and that the tax-free lump sum was here to stay.

But could it be reduced? The IFS also addressed this in its analysis and was more supportive of change. It suggested reducing the limit for tax-free cash to £100,000, or perhaps replacing tax-free cash with an across-the-board top-up to pension withdrawals that would make the system more generous to those paying no tax in retirement and less generous to higher tax-paying pensioners.

A problem, acknowledged by the IFS, is that such changes would apply to money contributed to pensions according to the existing system, leaving the government open to accusations that it was moving the goalposts retrospectively. It would also affect disproportionately more people in the public sector who enjoy more generous defined benefit pensions - a constituency the government will be loathed to upset.

IHT protections within pensions

Money held in pensions is treated differently on death from other assets. Pension money falls outside of a person’s estate for Inheritance Tax (IHT) purposes and can be passed to beneficiaries without IHT applying. If death occurs before age 75 then no tax applies, and if after age 75 then the beneficiary will pay Income Tax at their marginal rate.

This has made pensions a valuable tool for those seeking to mitigate their IHT liability. Changing the tax treatment on death of pensions may prove a complicated task but there are levers the government could pull, short of a full overhaul, to make the system less generous if it wishes.

Subjecting pensions to IHT could raise several hundred million pounds a year in the short term, the IFS said, but this amount would rise to closer to £2bn in the future.

With changes to IHT itself politically difficult to make, widening the tax to include pensions could be a way to raise money from the wealthier people Labour has said should shoulder the burden of tax rises.

Applying NI on employer pension contributions

Rumours have been gaining ground that the government could be about to widen National Insurance charged on the pension contributions made by employers for the benefit of their employees. This past weekend (30 September), Sir Steve Webb, former Pensions Minister and now partner at the consultancy LCP, suggested this change could be on the cards and industry publications has since reported that large pension companies have met with Treasury officials to discuss the change.

Currently, money paid into a pension by an employer for the benefit of an employee does not incur National Insurance (NI). Applying employer NI to employer contributions to a pension would raise huge amounts - £17bn a year according to the IFS - for the Treasury but could also reduce the amounts being saved into pensions by at least the same amount if employers pass on the cost to their workers.

A less dramatic change could happen where a lower rate of employer NI is applied to employer pension contributions - Sir Steve Webb and LCP suggested a level of 2%.

The IFS has also floated a more complicated change involving employee NI. This would involve giving tax relief from NI on pension contributions but levying NI on withdrawals. This would reverse the current situation where pension contributions are made after NI has been paid (except in cases of salary sacrifice) but no NI is due on withdrawals.

Amending the Personal Allowance for pensioners

You may remember the previous government’s promise to introduce a ‘Triple-Lock plus’ in the last election campaign.

This was the promise to raise the Personal Allowance - the amount we can earn before Income Tax becomes due - for pensioners to ensure that it was not exceeded by the value of the State Pension. The Personal Allowance currently stands at £12,570 a year, meaning that the whole of the current State Pension - worth £11,502.40 a year - falls within the Personal Allowance and can therefore be received without tax being due.

But the Personal Allowance is due to be frozen under current plans until April 2028. This means that, according to The Resolution Foundation2, estimated rises in the State Pension will see the payment exceed the Personal Allowance by 2028, meaning some of it is taxed at that point.

Labour did not match that promise in the election campaign, but it still has the same problem to overcome - that the standard full State Pension may start to be taxed during this parliament. It may not have to sort the problem at this Budget but a solution may be required before long.

Our latest Autumn Budget analysis

Source:

1 Raising revenue from reforms to pensions taxation, IFS, 11 September 2024
2 Under triple lock and key, Resolution Foundation, 29 May 2024

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Tax treatment depends on individual circumstances and all tax rules may change in the future. Withdrawals from a SIPP will not normally be possible until you reach age 55 (57 from 2028). This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.

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