Pension savers benefit from tax relief – which could become more generous if income tax were to be raised
Rachel Reeves is reportedly considering a rise in income tax at next month’s Budget – but is also mulling a cut to national insurance (NI).
This is despite Labour’s 2024 general election manifesto ruling out such a tax increase.
A rise in income tax would mean people paying more of what they earn to the Exchequer, with average earners facing bill hikes worth potentially hundreds of pounds a year.
Some of this could be offset by a cut to NI, though certain people, such as pensioners and landlords, do not pay NI at all, so would not benefit.
Below, we look at how a change would affect pensioners, and how those paying into pensions would be affected by the change, too.
Pensioners would pay more of their income as tax
People pay different rates of income tax depending on what they earn.
Currently, those in England, Wales and Northern Ireland pay 20 per cent on earnings between £12,570 and £50,270 – this is known as the basic rate.
People also pay 40 per cent – the higher rate – on earnings between £50,270 and £125,000, and 45 per cent – the additional rate – on earnings above this.
Most people under 66 also pay NI on their income, though those aged 66 or over do not, regardless of whether their money is coming from pension income or work.
A 2p rise in income tax, as is reportedly under consideration by Reeves, would mean a pensioner earning £25,000 from the state pension and private income would go from paying £2,486 per year in income tax to £2,734, an increase of around £250 per year.
If Reeves were to cut NI, pensioners would see no benefit because they do not pay it.
There is one silver lining. At the moment, pensioners can take 25 per cent of their pension pot as a lump sum entirely free of income tax. There is a maximum cap of £268,275 on this amount.
If this were to remain unchanged, then this tax-free giveaway would, in effect, become more generous, as it would give pensioners money tax-free that they would otherwise have paid 22 per cent income tax on, rather than 20 per cent.
Those paying into pensions could benefit
Working-age people would face the same impact from an income tax rise as pensioners, but if NI were to be cut by the same amount, then workers who were earning below £50,270 would be in exactly the same position as they are in now.
For workers earning above £50,270, the situation is more complicated, as they pay a different NI rate, and it is not clear whether Reeves is considering a cut to this rate.
A rise in income tax would mean that paying into a pension would be more valuable, though.
People get tax relief on payments into their pension at their marginal rate, so higher rates would mean more relief.
At the moment, those earning between £12,570 and £50,270 pay 20 per cent income tax, but if they pay into a pension from their wages, they are not taxed on the contributions. It means paying £1,000 into a pension effectively costs £800.
Higher-rate taxpayers – those earning £50,271 to £125,140 – pay 40 per cent income tax, and therefore get 40 per cent relief on pension payments, while those earning over £125,140 pay 45 per cent.
It is not clear if, or by how much, income tax could rise at the Budget, but an increase could make pension payments even more tax-efficient, assuming tax relief rules were not changed.
Rachel Vahey, head of public policy at AJ Bell, explained: “If a 2p increase to income tax at basic and higher rates were to happen, there will be an extra incentive for those affected to contribute to a pension, as the tax relief available will increase by 2 percentage points.
“For a basic-rate taxpayer, this would mean getting £1,000 in a pension would only cost £780, with £220 added through tax relief, compared to £800 today.
“For higher-rate taxpayers, the savings are even more impressive, especially if we assume higher-rate tax also rises by 2 percentage points to 42 percentage points. If that happened, then getting £1,000 into a pension would effectively cost the higher-rate taxpayer £580, compared to £600 today.”
Sarah Coles, head of personal finance at Hargreaves Lansdown, added: “Assuming income tax relief on pensions goes untouched, then any rise in income tax would make pension contributions even more valuable, because it would mean more tax relief.
“This wouldn’t leave people better off today, but would help them build towards a more resilient retirement.”
You do not get NI relief on employee pension contributions in the same way as you get income tax relief, so if income tax is hiked but NI cut, contributing money to your pension becomes cheaper than it is currently.
The exception to this is if you use a salary sacrifice scheme. This is where you agree to give up a portion of your salary, and in return, your employer pays an equivalent amount directly into your pension.
Doing this saves you money on income tax and NI, as you are being effectively paid less. As a result, if NI is lower, then this arrangement becomes less appealing than it is currently.
Other downsides to an income tax increase
Experts also explained that an income tax rise would mean people paying even more tax on their savings interest.
Basic-rate taxpayers can earn £1,000 in savings interest without paying tax on the money, while higher-rate payers can earn £500, and additional-rate payers nothing.
After this, they must pay tax at their marginal rate, unless they have the money shielded in an ISA. Interest on money in ISAs is tax-free.
“A tax rise will make a cash ISA particularly valuable. In an environment of rising taxes, tax-free things like pensions and ISAs come into their own, so it’s worth considering whether you can take more advantage of your allowances,” explains Coles.
There are rumours that cash ISA allowances could be cut at the Budget too. At the moment, savers can put £20,000 into an ISA each year – with the money funnelled into stocks and shares or cash.
Reeves is reportedly considering reducing the allowance that can go into cash ISAs.