The basics of pensions tax relief

25 October 2018

This article was featured in the November 2018 issue of the magazine.

Jill Smith MCIPPdip, CIPP policy manager, explains the rules on employee contributions 

 

All employers are now required to automatically enrol all eligible workers into a pension scheme. It requires a minimum total contribution, made up of the employer’s contribution, the worker’s contribution and tax relief. Although automatic enrolment regulations establish minimum levels required to satisfy legislation, the government does offer financial incentives to encourage individuals (and, where applicable, employers) to save for their retirement – and one of these is pensions income tax relief.

Tax relief is given on your pension contributions at the highest rate of income tax you pay, meaning:

  •  basic-rate taxpayers get 20% pension tax relief

  •  higher-rate taxpayers can claim 40% pension tax relief

  • additional-rate taxpayers can claim 45% pension tax relief.

In Scotland, income tax is banded differently, and pension tax relief is applied in a slightly different way: 

  • starter rate taxpayers pay 19% income tax but get 20% pension tax relief

  • basic rate taxpayers pay 20% income tax and get 20% pension tax relief

  • intermediate rate taxpayers pay 21% income tax and can claim 21% pension tax relief

  • higher-rate taxpayers pay 41% income tax and can claim 41% pension tax relief

  • top rate taxpayers pay 46% income tax and can claim 46% pension tax relief.

The way tax relief is obtained depends on the type of pension scheme you are saving into, and it may be useful to check with your scheme provider to see what method it uses. There are two main ways:

  •  relief at source scheme – pension contributions are deducted after the tax calculation has been performed

  • net pay arrangement scheme – pension contributions are deducted before the tax calculation is performed.

‘Relief at source’ (RAS) applies to all personal pensions and some workplace pensions. The pension contributions in a RAS scheme do not affect the calculation of taxable pay. Pension contributions are deducted net of tax at the basic rate (currently 20%). So, for example, a net pension contribution of £80 means that £100 is credited to the pension scheme – £80 from the individual and £20 from the pension provider. The scheme administrators will later claim the basic rate tax relief back from HM Revenue & Customs (HMRC). 

All individuals get the benefit of tax relief at the basic rate in a RAS scheme, regardless of whether they are a taxpayer or not. But the downside of this type of scheme for higher paid workers is that if they are a higher- or additional-rate taxpayer they must complete a self-assessment tax return to receive the extra relief due to them.

The ‘net pay arrangement’ is used by some workplace pensions and all public sector pension schemes and generally does not require you to do anything to get full tax relief. Your pension contributions are deducted from earnings before income tax is calculated, which means that you receive the benefit of tax relief at the point the contributions are deducted. 

For example, an employee decides to contribute £100 to the pension scheme each month. £100 is deducted from the employee’s gross pay, reducing the employee’s taxable pay, which reduces tax due by £20 (for a basic rate taxpayer). The employee’s actual contribution to the pension scheme is £100.

individuals get the benefit of tax relief at the basic rate in a RAS scheme

 

The issue with a net pay scheme is that tax relief is only given if the individual is actually a taxpayer. If the individual has taxable pay under £11,850 in 2018/19 they will not be paying tax but may be still paying pension contributions, as the value of the auto-enrolment earnings trigger is only £10,000. Therefore, those who are in lower-paid employments in a net pay pension scheme are losing out on tax relief through no fault of their own. How many low pay workers are aware of this?  If they were in an RAS scheme, their contributions would have been taken net of basic rate tax relief and would still have been grossed up by their pension provider.  

Pension scheme members who don’t pay income tax are permitted to basic rate tax relief (20%) on pension contributions up to £2,880 a year. In practice, this means that HMRC will top up a net contribution of £2,880 to a gross £3,600. However, this tax relief is only available where the employer operates a pension scheme on the RAS basis.

The government puts a limit on the amount of pension contributions (savings) on which you can earn tax relief in a year: 

  • The annual allowance – This limits the amount of tax relief available on pension savings in a tax year. For 2018/19 the allowance is £40,000, but the amount for a year can vary; for example, you can carry forward unused allowances from the previous three years.

  • The lifetime allowance – This limits the amount of tax relief available on pension savings in your lifetime. For 2018/19, the allowance is £1,030,000. If the total value of entitlements to pension benefits exceed the lifetime allowance, income tax is payable on the excess. You’ll get a statement from your pension provider telling you how much tax you owe if you go above your lifetime allowance. Your pension provider will deduct the tax before you start getting your pension. 

The way the lifetime allowance charge applies depends on whether you receive the money from your pension as a lump sum or as part of regular retirement income. Any amount over your lifetime allowance that you take as a lump sum is taxed at 55% and your pension scheme administrator should deduct the tax and pay it over to HMRC, paying the balance to you. If you take it as a pension payment or cash withdrawal the rate of tax you pay will be 25%.

You might be able to protect your pension pot from reductions the government makes to the lifetime allowance. To do this you would need to tell your pension provider the type of protection and the protection reference number when you decide to take money from your pension pot. 

 

...no employee pension contributions to receive tax relief

 

Salary sacrifice

In a pension salary sacrifice arrangement the employee gives up salary in exchange for an enhanced employer pension contribution. The arrangement serves to reduce, amongst other things, the employee’s income tax and National Insurance contributions but as the arrangement is for employer pension contributions there are no employee pension contributions to receive tax relief. 

 

More information about the different types of pension scheme is available from the Pensions Advisory Service website: https://www.pensionsadvisoryservice.org.uk. 

 

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