Tax relief is one of the best features of using a pension to save for retirement.
When you pay into a pension, scheme registered with HMRC, some of the money that would have gone to the Government as tax goes instead into your pension pot.
How does pension tax relief work?
There are two ways in which you can get tax relief on your pension contributions.
If you’re in a workplace pension scheme, your employer chooses which method you use; if you’re in a personal pension, you always have to use the relief at source method.
The easiest way to check which method your scheme uses is to ask your HR department (or whoever handles payroll for your employer) or, if you’re self-employed, your pension provider.
Relief at source
With the relief at source method, your pension contributions receive a boost from the Government matching the highest rate of income tax you pay: 20%, 40% or 45%.
In practice, this means for every £1 a basic rate taxpayer contributes to their pension, the Government tops it up by 25p because £1.25 taxed at 20% is £1; conversely, higher and additional rate payers see every £1 they contribute become £1.66 and £1.82 respectively thanks to tax relief on their contributions.
If you live in Scotland and pay tax at the Scottish starter rate of 19%, you still get tax relief on your pension contributions at 20%.
Here’s how the relief at source method works step by step:
- Your employer deducts tax from your taxable UK earnings as usual.
- They then deduct your pension contribution from after-tax pay and send this to your pension provider. If you’re self-employed, you will contribute your taxable UK earnings directly to your pension provider.
- Your pension provider then claims 20% in tax relief from the Government, which they add to your pension pot.
This method is better for people who don’t pay tax – for instance, if their income is below the personal allowance – as they still get tax relief.
However, people who pay higher income tax rates than 20%, whether employed or self-employed, have to claim the extra tax relief through their tax return or by filling out the necessary forms with their pension provider.
Net pay
Through the net pay method, you make your contributions before paying taxes. As a result, you will pay less tax as it will be calculated based on a lower amount of UK earnings.
Here’s how the net pay method works in more detail:
- Your employer deducts the total amount of your pension contribution from your pay before deducting your taxes.
- You then pay tax on your UK earnings minus your pension contribution. As a result, your tax bill will usually be lower.
- Although you’ve paid the total amount of your pension contribution yourself, you get the tax relief straight away by paying less tax.
Unlike the relief at source method, no matter the rate of income tax you pay, you get the entire tax relief without having to claim it.
However, this method means you won’t get any tax relief if you do not pay income tax.
Limits on tax relief you can receive
There is no limit on the amount of money you can put into your pension. However, there are limits on the amount you can save while claiming tax relief.
First, the Government only gives tax relief on pension contributions that are the higher of:
- 100% of your relevant UK earnings in a year
- £3,600.
For example, let’s say you put your £20,000 salary into your pension pot one year. Then add £5,000 you had set aside in savings. You would only be entitled to tax relief on the first £20,000, leaving you with a net contribution of £30,000. You do not get tax relief on contributions made by your employer.
If your relevant UK earnings are less than £3,600, your gross pension contributions are limited to this £3,600. That means only the first £2,880 of your payments will receive tax relief.
Secondly, only contributions within the annual allowance qualify for tax relief. Therefore, contributions that go over it may be taxable. This effectively claws back any excess tax relief given.
The annual allowance recently increased to £60,000, but it reduces if you have an adjusted income above £260,000.
This ‘tapering’ ends at £360,000, so everyone will always have an annual allowance of at least £10,000.
If you’ve triggered the money purchase annual allowance (MPAA), your allowance may also be £10,000. The MPAA is usually activated if you take your entire pension pot as a lump sum or start to take lump sums from your pension pot.
The annual allowance applies across all your pension savings – not per pension scheme. It also applies to combined employee and employer contributions.
However, you can use unused allowance from up to the previous three tax years to receive tax relief on higher contributions (this is known as ‘carry forward’, and conditions apply).
What counts as relevant UK earnings?
Tax relief on pension contributions is only available on relevant UK earnings, which include:
- income from employment (including salary, wages, bonus, overtime or commission)
- self-employment profits
- benefits-in-kind
- redundancy payments above the £30,000 tax-exempt threshold.
They don’t include the following:
- dividends
- savings income
- rental income which isn’t from a furnished holiday let
- pensions in payment
- state benefits.
To get tax relief on pension contributions, you must be a UK resident and below the age of 75.
How much can you build up in your pension?
There is no limit to the amount you can save in pensions. There was a lifetime limit on the amount you could build up without having to pay a tax charge when you access your pension or transfer it overseas.
However, the lifetime allowance which limited your tax-free pension pot to £1,073,100 is due to be abolish as per the latest announcement in the Spring 2023 This should happen in April 2024.
Any amount above the lifetime allowance was subject to a tax charge of 25% if paid as income or 55% as a lump sum, but the Spring Budget announced that from April 2023 the charge will no longer be applied.
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