When it comes to terminology, the pensions industry is often its own worst enemy. Nowhere is this more true than when it comes to explaining the difference between ‘net pay’ and ‘relief at source’ schemes.
Contrary to all common sense, relief at source schemes require net contributions while net pay schemes provide immediate tax relief. No wonder, then, that everyone is confused …
On the face of it, the net pay method – traditionally used by occupational pension schemes – looks more logical. The tax relief is automatic and it arrives – and can be invested immediately – without the six-week delay some basic-rate taxpayers have to endure, and a wait until the end of the year for higher-rate taxpayers.
The latter do not of course receive their relief if they forget to ask for it at the end of the year – a distinct possibility as we can all be forgetful, and indeed a real probability if somebody has never been told about this box on their tax return.
There is, however, a nasty wrinkle in the system for employees who earn less than the nil-rate tax band and so do not pay tax. Under net pay arrangements, they pay no tax and so receive no relief. Yet, under relief at source, HMRC automatically send 20% to their pension pot even though they are non-taxpayers.
While this problem has existed since the introduction of personal pensions back in 1988, it has been brought into sharp focus by the large number of low-earners now being auto-enrolled.
Until April 2015, both the nil-rate tax band and the auto-enrolment earnings threshold were £10,000 per year. That meant employees eligible for auto-enrolment were also taxpayers and therefore received tax relief regardless of which method of contribution their pension administrator adopted.
From April 2015, though, the auto-enrolment earnings threshold remained at £10,000 but the nil-rate tax band was increased to £10,600. For the 2016/17 tax year, the nil-rate tax band increased to £11,000 and then to £11,500 for the 2017/18 tax year.
This means that in the 2017/18 tax year, for a non-taxpayer making auto-enrolment minimum contributions, they could miss up to £11.25 of tax relief. This number will only rise in coming years as the starting point for income tax rises and the minimum contribution rates for auto-enrolment increase.
The recent review of auto-enrolment made a number of recommendations to increase the coverage and improve the adequacy of auto-enrolment, including lowering the eligible age from 22 to 18 and changing the rules so that contributions are on every pound of salary, not just on a band of earnings.
Opportunities ‘to look afresh’
We wholeheartedly welcome these proposed reforms, even though they will potentially exacerbate the net pay anomaly. The report says that, as part of the digitisation of the tax system, there may be opportunities “to look afresh at the two systems of paying pension tax relief”.
To address this issue for our members in the interim, NOW: Pensions is offering to make up the income tax relief shortfall for all our members who are not taxpayers. While this may be a short-term fix, however, it is not a long-term solution. Neither is moving to relief at source, as that simply shifts the problem from low-earners to people earning more than £45,000 (or £43,000 in Scotland).
We will continue to press HM Treasury for a solution so employers do not have to choose between two methods of tax relief and no saver has to worry about missing out.
Adrian Boulding is director of policy at Now: Pensions
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