What is the point of pension tax relief - can't we scrap tax in retirement instead? STEVE WEBB

Please can you help with this question, as I'm having difficulty in trying to understand why we have pension tax relief.

Why does the Government give us 20 per cent tax relief when we are saving into our private pension pot, but then when we get to retirement age some of us will have a full state pension, which at present is just under £12,000 per year.

The personal allowance is £12,570, so the Government then charges us on anything over that at the basic tax rate of 20 per cent.

Would it be better to not offer the 20 per cent tax relief on pensions, then when we get to pension age they don't charge us any tax on any pension money saved up over the years of hard work?

Sorry if it's a silly question, just struggling to get my head around it!

Steve Webb replies: Broadly speaking, there are two different ways in which savings are taxed in the UK.

The first is that you pay tax as soon as you earn the money but if you invest that money there is no further tax on your investment returns. This is the way that ISAs work, and is roughly what you are suggesting in your question.

The second is that if you earn money and invest it for later life you pay no tax on that money now, but pay tax when you draw it out. This is, broadly speaking, the way that pensions are taxed in the UK.

In principle, both of those approaches should amount to much the same thing. In both scenarios you pay one lot of tax, either at the start or at the end of your investing journey.

Of course, if you save in an Isa rather than a workplace pension then you miss out on the money your employer will pay in to a pension.

But, even ignoring the employer contribution, there are a couple of respects in which the way pension tax works is more favourable than the tax treatment of an Isa.

The first is that 25 per cent of any pension pot can generally be taken free of income tax.

This means that you pay into a pension free of a tax, pay no tax on the investment returns within the pension, and then get a quarter back tax free.

This is clearly a very favourable tax treatment, and much more favourable than a world where you simply pay tax once at the start and then nothing further.

The second potential advantage of the pension approach is that you get tax relief at your marginal rate of tax on the way in, and in many cases this will be higher than your tax rate in retirement when you take the money out.

Suppose, for example, that you put £100 gross into a pension while you are of working age and suppose that you are a higher rate taxpayer.

The cost to you of making this contribution is just £60 because the other £40 is the tax break on your gross contribution.

But suppose that in retirement you are a basic rate taxpayer. When you take the money out again you would only have a tax bill of £20 on the original £100 (ignoring investment growth in the meantime).

This is a big tax advantage compared with a system where you pay 40 per cent tax on your income when you are working but pay nothing in retirement.

The number of people who potentially benefit from this ‘tax rate shifting’ between working age and retirement has been growing sharply in recent years.

According to HMRC, a decade ago there were 4.3million people paying income tax at the higher 40 per cent rate, and a further 328,000 paying at the additional 45 per cent rate.

But last year these numbers had grown to 6.3million and 1.1million respectively. This means that the total number of people potentially getting more than basic rate relief on pension contributions has gone up from around 4.6million to around 7.4million - and increase of more than half.

Read More

A small number of these people will still be higher rate taxpayers in retirement and may not benefit from ‘rate shifting’, but the vast majority of pensioners who pay tax do so at the basic rate.

The latest figures suggest that more than nine in ten taxpaying pensioners are paying at the basic rate.

This means that any of these who received tax relief at the higher rate will enjoy a further tax advantage by saving in a pension compared with saving through an Isa out of already-taxed income.

There is one further reason why a switch to taxing people up front and then making pensions tax free might not be a good idea.

This relates to the fact that we have a rapidly ageing population. In years to come we will need to find a lot of tax pay for the promises we are making to tomorrow’s retirees, whether in the form of state pensions, unfunded public service pensions or simply delivering the health and social care which they need.

If a Chancellor chose to switch pensions tax round so that all the taxation happened at the start this would be great news for today’s politicians, and former Chancellor George Osborne had a good look at this idea in 2016.

But it would be terrible news for future generations of workers. In this scenario, tomorrow’s retirees would be paying no tax, but making heavy calls on public services, leading to an even higher tax burden on tomorrow’s workers.

Whilst the current system has many complexities and might be regarded by some as unduly generous to the better off, there’s no doubt that the current pension tax regime is more favourable for most people than the Isa regime.