How George Osborne's Budget could still hit pensions – by cutting tax-free cash and restricting the annual allowance further

Richard Harwood
Merkel And Osborne Attend German Industry Gathering
Osborne could ruin his chances of becoming Prime Minister if he cuts the tax-free cash (Source: Getty)

For a long time now, the nature of pensions savings has been that contributions are treated as deferred pay. In other words, you get tax relief on the way in and you are taxed on withdrawals.

Public statements by the chancellor suggest that he views pensions differently. For him, the issue is not so much allowing people to defer the tax they owe, but about the pensions system being a “cost” to the Treasury. This is shown in auto-enrolment: rather than people receiving “tax relief” on their contributions, it is now described as being a “government contribution”.

Read more: Budget 2016: A spread of tax changes are coming

Although the chancellor is not expected to announce any radical reforms this year, all the signs are that George Osborne still wants to “save some cost” from pensions. So what could happen in the long term, and what changes could still come today?

What could happen in the long term?

There are two major options open to the chancellor. The first is cutting higher rate tax relief.

This sounds simple and presumably could be billed as a benefit cut for the wealthy. But it is fraught with problems. If someone pays a £10,000 gross contribution to a personal pension, they would actually pay £8,000 net and receive basic rate tax relief at that point. A higher rate taxpayer would claim the additional 20 per cent via their tax return, and it would be very easy for the chancellor just to stop that.

But what if it is a company contribution? Would tax be due by the member as a benefit in kind? What if it is a final salary scheme where a benefit is accrued as a pension at retirement, not as a contribution? How would the tax be calculated? Every civil servant, soldier, policeman, nurse or politician who has earned over the higher rate tax threshold would therefore get an additional tax bill. Not so simple anymore.

Read more: Why Osborne has created a Budget rod for his own back

The second option open to Osborne is to turn pensions on their head and create an Isa-style pension. By ensuring that all contributions come from net income – and pension withdrawals are untaxed – it would throw the whole system in the air. There would be losers from this reform too. It is common for individuals to be higher rate taxpayers now (and therefore enjoy higher rate tax relief) but be basic rate taxpayers in retirement. They would almost certainly be worse off under a Pension Isa.

Both of these proposals have been shelved for now because they would be too complex to administer and perhaps because some people had calculated the true impact.

But the impetus for change hasn’t disappeared. For the chancellor, with his current economic challenges, there will always have to be a drive to save money if his targets are to be met.

What could happen in today’s Budget?

If there is a way of trimming the edges and cutting relief for higher earners or contributors, I suspect Osborne would not be able to resist it. There could perhaps be a further cut to the annual allowance (the maximum contribution an individual can make and receive tax relief). Top rate taxpayers are already facing the so-called taper, which will limit the annual allowance for those earning above £210,000 to just £10,000.

Another option would be for the chancellor to cut the tax-free cash. The term “tax-free cash” has not existed since 2006. It is now referred to in the jargon as the “pension commencement lump sum”, which is a lump sum a saver can take from his or her pension from the age of 55 where the tax rate is zero. It would not necessarily be hard for the chancellor to put a maximum limit on this. He could add a cap at £100,000, for example, or apply a small amount of tax, say 5 per cent.

The chancellor may think such changes will not seem penal and they would likely raise revenue for the Treasury. But any change could quite easily be seen as very radical indeed and could well be enough to prevent him from ever becoming Prime Minister.

Keep on top of the latest Budget 2016 stories as they happen with our live coverage here or follow @CityAM on Twitter for updates.

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.