Pension tax relief doesn't work, says think tankQuestions raised about effectiveness of incentives

16 July 2013

Hands holding two eggs saying retirement and nest egg

Tax relief on pension contributions does little to encourage saving, particularly among low and middle earners,  a new report from the Pensions Policy Institute (PPI) has claimed.

The PPI says there is limited evidence that tax incentives are effective, citing low levels of public understanding about how the system works and a 'savings gap' between how much people save, and how much they will likely need in retirement, as evidence. 

And the report, part-sponsored by Age UK and the Trades Union Congress, found that while tax relief offers important advantages to pension savers, especially higher-rate taxpayers, basic-rate taxpayers are estimated to receive just 30% of tax relief, despite making 50% of pension contributions.

Incentives worth £35bn a year

In order to encourage you to save for your retirement, and to ensure you don't pay tax twice on the same income, when you make a pension contribution the government will top it up with tax relief. 

If you are a basic rate taxpayer, tax relief will be 20%, meaning an £800 pension contribution will be supplemented with £200 from the Treasury - meaning you put in £1,000 altogether. 

Higher-rate taxpayers benefit from 40% tax relief, so a £1,000 pension contribution will effectively cost just £600. Additional-rate taxpayers benefit from tax relief at their top rate of income tax - 45%

When you come to retire, a further tax incentive means you are entitled to receive a lump sum of up to 25% of your pension's value tax-free. The PPI estimate that, added together, tax reliefs for pension savers cost the government £35bn a year.

Pension saving still advantageous

Despite its misgivings, the PPI is clear that pensions contributions are advantageous, tax-efficient savings products, whatever your tax position. It states that, based on a £1,000 contribution invested each year between age 40 and 67, both basic and higher-rate taxpayers would receive more in tax incentives from a pension than an Isa.

But the report is clear that higher-rate taxpayers benefit the most, especially if they become basic-rate taxpayers in retirement. This is because they get higher-rate tax relief on pension contributions but only pay 20% tax when drawing an income in retirement.

The PPI suggests a more equitable system would offer a flat rate incentive, where savers benefit from 30% tax relief on contributions regardless of their tax bracket. It says that this could be achieved with the same overall £35bn cost to the Treasury.

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