Will Labour change the rules on pension tax relief?

Pensions have been an important focus for Keir Starmer’s government since it was formed earlier this month.

Documents released shortly after the King’s Speech set out a new Pension Schemes Bill. A two-stage pensions review was also launched by chancellor Rachel Reeves this month.

So far, measures have largely focused on making the pensions landscape more efficient and productive for savers, while driving investment into the UK economy.

However, savers are now wondering whether tax could be under the spotlight in Reeves’s Autumn Budget , which could take place as soon as September. One area of speculation has been whether Reeves will change the rules on pension tax relief .

Under current measures, savers are entitled to tax relief on any money they pay into their pension pot. This is essentially a refund at your marginal rate. If you are a basic-rate taxpayer, you will get 20%, while higher and additional-rate taxpayers are entitled to 40% and 45% respectively.

This is a generous benefit which encourages pension saving. Most people are entitled to tax relief on contributions up to the value of £60,000 each tax year – although this includes employer contributions and the HMRC rebate as well as your own contributions.

The government hasn’t said anything about pension tax relief so far, but there has been speculation that Labour could change the rules to make them less generous for higher and additional-rate taxpayers.

Some commentators say the government will need to raise revenue somehow to fund spending on public services – and it has already ruled out hikes to income tax, National Insurance and VAT .

Some of the language being used by the government in recent days could be interpreted as laying the ground for tax hikes ahead.

During his first Prime Minister’s Questions on 24 July, Starmer warned that the country is facing “a more severe crisis than we thought as we go through the books of the last 14 years.”

Reeves is also reported to have warned cabinet ministers that she faces “difficult decisions” on tax rises and public spending as she prepares for her first Budget this Autumn. Reeves is expected to deliver a statement to Parliament on the state of the public finances on Monday, 29 July.

Truth or speculation?

“The potential for a raid on retirement savings incentives is a rumour that usually does the rounds before a Budget,” says Tom Selby, director of public policy at AJ Bell.

In Labour’s case, this perhaps hasn’t been helped by the tax rumours that were doing the rounds on the campaign trail. In one of the pre-election debates, former Prime Minister Rishi Sunak accused Labour of planning to raise taxes by more than £2,000 for working households.

This statement became shrouded in controversy after Treasury civil servants distanced themselves from the calculations used to arrive at the figure.

However, tax remained a contentious topic in the race for Number 10, with Sunak even accusing Labour of planning to introduce a “ retirement tax ” after the party said it would not match the Conservatives’ promise to unfreeze the personal allowance for pensioners.

Scrapping the higher and additional-rate tax relief on pensions in favour of a flat rate could raise billions for the Treasury. Estimates from the Institute for Fiscal Studies suggest imposing a flat rate of 30% for everyone could generate £2.7 billion annually.

However, in reality, reforming tax relief rules could prove challenging.

“A huge chunk of any potential savings to the Treasury from a pension tax relief raid would come from defined benefit (DB) schemes, the majority of which now reside in the public sector,” says Selby.

He adds: “If a flat rate of pension tax relief below 40% were applied on these schemes, the only way to ensure the correct level of tax relief was applied to contributions from higher and additional-rate taxpayers would be to hit those members with a tax charge likely running into thousands of pounds.

“This would therefore risk opening up a blistering row with NHS staff and civil servants at a time when many public services are already stretched to breaking point.”

What options are available to the government?

Introducing a flat rate of 30% pension tax relief would be “the nuclear option”, according to Gary Smith, partner in financial planning at wealth management firm Evelyn Partners.

As well as proving potentially invasive to public sector defined benefit schemes, it would probably involve dismantling private sector salary sacrifice schemes, he says.

That said, other options are open to the government, such as cutting the annual tax-free pension allowance from its current level (£60,000).

“We might also see some kind of death tax applied to pension funds, as that would also remove an anomaly that think-tanks have been criticising,” says Smith.

He adds that these measures could be implemented without impacting public sector schemes.

Cutting tax relief could discourage pension saving

Apart from proving politically unpopular, another reason the government could be reluctant to tinker with the rules around pension tax relief is that doing so could make pension saving less attractive.

The government is on a mission to boost investment in UK markets and the economy, and sees pensions as an important vehicle for doing this. Retirement savings are one of the biggest sources of investment capital.

Current tax relief rules mean that pensions are an attractive option for savers. Pensions offer more generous tax incentives than ISAs , for example.

“Reducing the upfront incentive for people to save in a pension would run counter to wider government efforts to boost long-term investing and risk undermining the flagship automatic enrolment reforms,” says Selby.

“In addition, younger people who are less likely to have benefitted from higher-rate tax relief may feel understandably aggrieved that a benefit offered to the previous generation has been ripped away from them,” he adds.