Pensions tax relief rates could be overhauled, as the Treasury has launched a consultation to address an anomaly that penalises low earners in defined contribution (DC) schemes.
Under current rules, the government tops up pension contributions in the form of tax relief, and the amount you get is equivalent to the rate of income tax you pay.
However, many of the lowest earners who aren't paying income tax in certain workplace pension schemes aren't receiving tax relief on their contributions. If you don't pay income tax, it's only available where the pension scheme operates on a relief-at-source (RAS) basis.
The government wants to know whether it should address the discrepancy for low earners by introducing new measures to include tax breaks for all pension savers.
Here, Which? explains how tax relief works in more detail and looks at how the system could be overhauled.
Tax relief is paid on your pension contributions at the highest rate of income tax you pay. So:
For example, if you're a basic-rate taxpayer and were to contribute £100 from your salary into your pension, it would actually only cost you £80.
There are two ways in which tax relief is provided by the government, depending on the type of scheme you're in. If you're a member of:
The government is considering abolishing this net pay method for delivering tax relief, proposing that all DC schemes switch to a method where only a basic-rate tax top-up is paid directly to a member's pot.
In other words, schemes would be required to switch to a RAS method, so that all scheme members would receive 20% tax relief, regardless of whether they pay income tax.
Quilter head of retirement policy Jon Greer says: 'At first glance, it appears the government is leaning towards mandating the use of relief at source for all defined contribution schemes. This certainly has appeal, as there isn't an extra lag between the pension contribution being made and receiving a bonus.'
Making these changes would be good news for millions of low earners who would receive more in their pot in retirement.
Lizzy Holiday, head of DC master trusts and lifetime savings at the Pensions and Lifetime Savings Association, says: 'The publication by the government of a call for evidence on the net pay/relief at source issue shows long-overdue progress towards fixing thetax anomaly that is leaving 1.75 million of the lowest-paid pension savers in “net pay arrangements” worse off.
'On the minimum auto-enrolment contributions [which is 3% for employers and 5% for employees], those affected are losing up to a total of £63 a year each, and in many schemes it can be at least double this figure. Of the affected population, over 75% are female.'
According to Quilter, the net-pay anomaly means some workers earning £12,499 a year could retire with a pot worth £59,000 under the RAS scheme, while those in net-pay arrangements would end up with £51,000.
This assumes 4% net investment growth after charges in both cases, and a retirement age of 68.
However, if net pay schemes are abolished it would mean that millions of higher earners could lose automatic tax breaks on their contributions and would have to reclaim pensions tax from HMRC above the basic rate.
If people fail to fill out a self-assessment, they could be missing out on additional tax relief they're entitled to.
It has been set at £40,000 for the tax year 2020-21. Any pension payments you make over the £40,000 limit will be subject to income tax at the highest rate you pay.