The Revenue views pensions as deferred pay. That is, if you save 10% of your income in a pension fund, then you will only pay income tax on the 90% which you declare as earnings this year, and the 10% in the pension will be taxed as income when it is paid in a future year.
The pension fund is normally invested and prior to 1997, both investment income and capital gains which rolled up in the fund were tax free. Dividends received from UK companies carried a tax credit to represent corporation tax, and this could also be reclaimed by the pension fund. Gordon Brown stopped the reclaiming of dividends in 1997, which amounts to retrospective legislation since had I known what Gordon Brown was going to do, I might not have made any pension contributions at all in the 1980s and early 1990s.
Once a person retires, the pension fund was used to buy an annuity, which is an insurance contract which guarantees an income for life. If the person dies the day after buying the annuity, then nothing will be paid, but if the person lives a long time, then the insurance company will make a loss.
Why should pension contributions be privileged by the deferred pay system at all? Well if someone saves up for a pension and buys an annuity, then they are unlikely to be so impoverished on retirement that they fall back on the resources of the State. That’s a good reason to have such a system.
However, we have a new pensions regime where the purchase of an annuity is no longer essential. You can just draw on your pension fund year after year, and it will be duly taxed as deferred income. Many people don’t like the idea of an annuity where you could lose everything if you die too early, and so they may opt for an income drawdown system instead.
However, with no annuity it is possible that a pension fund taken as income drawdown will run out of cash. The retired person will then become impoverished and turn to the State for help. This defeats the purpose of the deferred pay system. We can therefore expect to see relief for pension contributions being withdrawn in the future. It will be withdrawn first for taxation at the higher rate, and then for taxation at the basic rate. This is what happened with tax relief on mortgage interest payments and also on the married couple’s allowance. We will see.
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