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Gnawing at carrots

It has been reported that the Chancellor is expected to resist any immediate change to the pension annuity system.

The current rules require that any part of a pension fund not taken as permissible tax-free cash is used to purchase an annuity at an age not later than 75 as the means of providing a pension from any approved occupational or personal pension arrangement.

It is possible, however, that a broader review of effective saving to provide for retirement may be undertaken to take full account of the current negative feeling about the lack of flexibility in pensions.

A key factor for the Government in any reform will be balancing the fiscal books. While there is tax relief on contributions to pension plans, there has to be a counterbalancing tax on the output – the pension.

It is well known that many in official circles view the much-loved tax-free cash as anomalous. Leaving aside the tax-free cash, if there is to be any kind of freeing up of pension funds, it should not be seen as surprising if there needs to be some corresponding give on the part of the taxpayer. This could be in the form of a scaling back or even abolition of tax relief on contributions or the imposition of tax on amounts withdrawn from the fund.

The drawdown rules may offer a precedent here. It is relatively well known that one of the many attractions of drawdown is the effective preservation of the remaining fund for the family or dependants of the member on his or her death during drawdown before age 75. While, in most cases, the sum payable will be free of inheritance tax, there is a 35 per cent income tax charge. A similar charge could easily be applied to any amounts withdrawn from the pension pot outside the drawdown limits. Any amounts taken within these limits could continue to be taxed as income in the usual way.

In the US, holders of Individual Retirement Arrangements have the option, within limits (under the Roth rules), to take their pension fund in cash but there is a tax penalty for doing so. There are also the fairly well publicised Irish rules to consider.

The alternative of removing tax relief at the front end is one that has raised its head a number of times in the past. If this is done, then we could truly be moving towards a freeing up of wrapper choice for retirement investment.

Even now, there appears to be evidence that, once a reasonable level of income is secured, some people demonstrate a reluctance to put further funds into a pension fund environment because of how the benefits must be taken. If tax relief at the front end were taken away, then one of the main reasons for choosing pensions over other wrappers would disappear.

There could, however, still be freedom from income tax and capital gains tax on the fund investments. It is here that the choice would become interesting based on the current rules. If we had a pension that permitted all benefits to be taken in cash free of tax, gave no tax relief on input and offered tax freedom on investments inside the wrapper – is this not an Isa? The answer is yes, save for the fact, that under current rules, Isa managers can reclaim the 10 per cent tax credit on UK dividends until April 2004.

There are other differences to consider. There are different limits on input to pensions and Isas. Could these continue to be justified if the changes just described were implemented? The answer is probably not.

So would we just move to a single tax-advantaged savings wrapper with no tax relief on input, tax-free income and gains and no tax on (or limitation on the form of) benefits taken?

Well, I suppose we would but then one could expect to see some limits on how much could be contributed to such a scheme or some further rules about when benefits could be taken. After all, the Government uses tax and tax relief as a key means of persuading people to invest in a particular way. If there were no limits or rules, then we would just move to a completely open method of saving and remove the main differences between Isas and other collectives.

Where would this leave life insurance as a wrapper for savings if all non-life collectives could be invested in without limit and benefits could be taken in any form at any time free of tax, with gains and income inside the wrapper being tax free?

The life insurance policy, single or regular premium, would look a tax-disadvantaged means of investing unless something were done to ensure that life funds bore no tax at all and all benefits could be taken tax-free regardless of the investor&#39s tax position.

In light of this, you may conclude that abolition of all tax on all savings with no limits imposed is highly unlikely. The loss to the Exchequer may be a little too high for it to contemplate such a move.

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