Pensions will still be the most effective way to save even if higher earners get less tax relief under the chancellor's expected reforms, according to the Institute of Fiscal Studies (IFS).
In The effects of taxes and charges report published today, the IFS said that higher earners facing higher marginal tax rates had greater incentive to save as the 25% tax-free lump sum is greater for those who face higher rates of income tax in retirement.
It estimated that ‘baby boomers' that pay a higher rate of tax throughout their working lives spend on average two thirds of their retirement as basic rate tax payers. The report argued that planned reforms to pension taxation would make it harder for an individual to be a higher-rate taxpayer on the basis of one's pension income.
It also said the effect of auto-enrolment (AE) means that pensions are the most effective way to save for retirement because the employer puts in £3 for every £5 that the employee and the government (through tax relief) put in. This means the employee receives a 60% bigger pension than without the match.
As employers rarely make equivalent offers to match employees' contributions to an ISA or a house, it makes saving into a pension much more attractive relative to other assets, the IFS argued.
The report comes ahead of the March Budget when the government is expected to announce tax relief reform either a flat-rate of tax relief or the more radical ISA-style TEE (tax, exempt, exempt) system.
The IFS acknowledged that moving to a flat rate of relief would discourage higher earners - but only if the rate of relief were less than 30%. If the rate were less than 30%, higher-rate taxpayers who would go on to pay a higher rate of tax in retirement would be "actively discouraged" from making employee contributions.
Yet the report said recent changes to taxation on lifetime allowance and annual allowance had created a lot of uncertainty about pensions. With the government is proposing yet more reforms, the IFS said this uncertainty could make it difficult for individuals to plan for their long-term retirement savings.
PP recently looked at whether an exodus of higher earners from further tax relief reform could damage pensions.
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