Contractors have only until the end of the tax year to make last-minute pensions contributions before the Government introduces what experts believe will be draconian restrictions on pensions tax relief in March’s 2016 Budget.
Although largely speculation at this stage, everything we do know about the Government’s plans for pensions reform and tax relief restrictions will impact negatively on high earners, including contractors.
All the indications suggest that restrictions on pensions tax relief will be announced on 16 March 2016 and could take effect immediately. Contractors with underfunded pensions or large cash savings in their company have only weeks to make tax efficient contributions to their pension before the new rules take effect.
The loss of tax relief could mean savers lose out on the compounding contribution tax relief achieves over the long term and so reduce pension values by as much as 17%, leaving contractors with retirement incomes lowered by 7%.
Restricting contractor pensions tax reliefs could generate billions
Government pensions and other registered schemes cost the Exchequer an estimated £36bn in lost tax revenue, and the Chancellor George Osborne wants to claw some of this back.
The bottom line is that higher rate tax relief on pensions contributions costs £7bn a year, so higher earners are clearly a target for the Chancellor. However, the options the Government is believed to be considering could be much wider in scope.
What pensions tax relief changes are being considered?
Although no one knows for sure what changes will be made, the pensions industry understands changes are definitely coming and have a pretty good idea of what they might be based on what the Government has said during the consultation phase.
One option is thought to be a flat rate tax relief on pensions. At the moment, contractors receive the highest marginal rate of tax relief. A flat rate scheme would mean the same rate of tax relief applies to all taxpayers. We know that higher earners can expect a reduction on tax relief based on earnings, but that flat rate is likely to be below 40%.
Experts involved in the consultation are saying the rate could be 25%, 30% or 33%. This would leave most contractors worse off, although basic rate taxpaying contractors would be better off. A flat rate scheme is expected to raise an additional £6bn in tax.
Employers may no longer make gross pension contributions
It has not been confirmed how tax relief may be applied, so another solution being considered is to tax gross pension contributions paid by employers and force employees to claim the tax relief via self-assessment.
The pension contribution would be added to the contractor’s salary paid by their limited company. This would then be taxed at the employee’s marginal rate, so a contractor on the higher rate of tax would pay 40% tax on the pension contribution.
The tax relief would then be paid into the pension fund. This would mean that a contractor’s limited company would pay the contractor and not directly into the pension fund, adding further costs and complexities.
Contractor pensions could move to an ISA-style structure
There may be a move from the current exempt tax situation that pensions currently enjoy to a structure similar to how ISAs work: At the moment, all contractors pay in to their fund tax exempt, the fund growth is tax exempt and they are then taxed on their pension income – this is known as ‘exempt, exempt, taxed’.
The alternative is to turn around the current situation so it is ‘taxed, exempt, exempt’. This means contractors would pay tax on contributions, but then pay no tax on the fund growth or on the resulting income on retirement. This is similar to how ISAs work.
This is a highly attractive alternative because it is believed that an ISA-style structure could raise £19bn of tax revenue each year. Although this is a good move for the Chancellor, experts are warning that it is a short-sighted option as it is a disincentive to save as psychologically savers won’t see any benefit.
When will the changes to pensions tax relief take place?
Opinion over the timings of the changes is split: The measures are expected as part of the 2016 Budget delivered in March – that’s not in dispute. But some pensions experts believe that the changes will take effect immediately.
Others think that there will be a 12-month delay and the changes will take effect from April 2017. The upshot is that we don’t know for sure, but to be on the safe side contractors must take action now, particularly if they have an underfunded pension or if they have a significant cash balance in the business.
Paying a lump sum into a pension scheme before April 2016 would also have the added benefit of extracting cash tax efficiently before the dividend tax changes take effect from April.
We don’t know what the Chancellor will say on 16 March, but it almost certainly won’t be positive for higher earners. Contractors should take action and speak to their pensions adviser now to see what can be done before the end of the tax year.