Tax-Free Pension Loophole Leaves Chancellor Stuck

Chancellor George Osborne seems to have painted himself into a corner over tax on pensions with his raft of new measures to help over 55s have easier access to their pension cash.

On the one hand, Osborne has swept away annuity rules and complicated drawdown rules that more or less allow anyone with a defined contribution or personal pension take what they want, when they want from their retirement savings.

But tax experts are pointing out a huge loophole in pension rules that could cost the Treasury billions in tax if workers were to take advantage of an arrangement called ‘salary sacrifice’ in their last year of working.

For those that can afford to do so, salary sacrifice means instead of drawing a wage, the money is paid straight into a pension scheme.

Salary sacrifice

The advantages are no national insurance is charged on the contribution, saving 12% on payroll tax and topping up the contribution by the taxpayer’s marginal rate of tax.

Salaried workers could pay up to £40,000 a year into their pension as salary sacrifice under current rules.

Then, as soon as they are 55 or their pension scheme allows drawdown, they can take a 25% tax-free cash lump sum from their pension and pay income tax on the rest they draw down.

The Treasury reckons this tax loophole could cost the government around £24 billion a year if left open.

Others believe the Chancellor will leave the loophole but if the Tories win the next general election in 2015, will start chipping away at the 25% tax-free lump sum to claw some or all the money back.

Problem still the same

“Osborne’s probably aware that announcing plans to remove the tax free pension lump sum would pretty much be suicide for the Tories as next year’s election approaches,” said Ray Chinn, of pension provider LV=.

“It’s more likely that if the tax free money is going to go, it will be over a number of years.”

However Chinn, along with other pension experts, points out that whatever the Chancellor does with incentives to save, the same problem remains.

“The bottom line is people are just not putting enough money into savings for their later life,” he said. “People need to appreciate that they only earn during a third or so of their life and need to spread that cash out over up to 30 years in retirement for the youngest workers today.”

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