Pension contributions and tax relief: what you need to know
Jonathon Jay of DSW Wealth Planning cuts through the jargon and explains how to make the most of the tax incentives
Pensions are a tax-efficient way to save for retirement but can be difficult to understand, especially when it comes to pension contributions. Here, I will explain the key issues about contributions and tax relief and some of the common terms you might come across.
How much tax relief can I claim?
The amount of tax relief you can receive on personal contributions depends on your taxable earnings, the rate of income tax you pay, where you live in the UK, and how much your annual allowance limit is for the tax year.
You will receive income tax relief based on your highest marginal rate of income tax. For example: if £10,000 of your income is in the higher rate tax band and the remainder in the basic rate bracket and you decide to make a gross pension contribution of £20,000, you would receive higher rate tax relief on £10,000 and basic rate tax relief on £10,000. The same principle applies to additional rate taxpayers. Higher earners may also benefit from reclaiming lost personal allowance in some circumstances giving them an effective rate of 60% tax relief on some of their contributions.
Scotland has five income tax bands rather than three like the rest of the UK, but the methodology of calculating the amount of tax relief on pension contributions is the same.
Personal contributions are capped each tax year at the higher of 100% of your UK taxable earnings and £3,600. This cap doesn’t include any employer contributions but does include any third-party pension contributions made on a person’s behalf.
Employers receive tax relief on any contributions paid by them into pension plans through their business accounts. The amount of contributions paid is unlimited however the tax relief is limited to the profits during the trading year, and they cannot create a loss.
As well as the tax relief and limits described above, the annual allowance is the total overall amount you can put in your pension fund each tax year from all sources without having to pay a tax charge. The standard annual allowance is currently £40,00 however there are some considerations which may affect this:
- Unused annual allowance – you can carry forward any unused annual allowance from the previous three tax years provided you were a member of a pension scheme during that time. You could therefore potentially make total overall contributions of up to £160,000 if you had the full carry forward entitlement. Remember though that your own personal tax-relievable contributions in any given tax year are limited to 100% of your earnings or £3,600 if more.
- Money purchase annual allowance (MPAA) – if you have accessed income from your pension funds using one of the various flexible benefit options, then any further money purchase contributions will likely be subject to a reduced annual allowance which is currently £4,000 per annum. This is known as the money-purchase annual allowance or MPAA. Any unused MPAA cannot be carried forward.
- Higher earners – for those with a total taxable income above £200,000, you may be subjected to a tapered amount of annual allowance. This is a complex area and personal advice should be taken if you think you are affected by this.
Does it make any difference who pays the contribution?
The method of contribution does not change the total amount of tax relief received however personal contributions may be made in different ways and the claim for tax relief varies for each method. All employer contributions are made on a gross basis as explained above.
- Individuals paying directly into a pension scheme from their own bank account or making third-party contributions on behalf of another person, such as a grandchild, will pay contributions net of basic rate tax regardless of their actual rate of taxation. The pension provider will reclaim the basic rate tax from HMRC and add this to the pension plan. Higher rate and additional rate taxpayers reclaim the additional tax relief from HMRC through self-assessment. This is known as the ‘relief at source’ method.
- Individuals making contributions through their employer’s payroll with either have contributions deducted, net of basic rate tax, from their take-home pay and tax relief applied in the same way as above, under the relief at source method. Alternatively, some employer pension schemes deduct the gross contribution from the gross taxable pay before the deduction of income tax effectively granting full tax relief immediately with no need to reclaim anything. This is called the ‘net pay’ method.
- Some employers allow employees to reduce their salary in exchange for an employer pension contribution of the same amount. This is known as ‘salary sacrifice’. The income tax position is generally neutral however both the employer and employee will pay less National Insurance. Advice should be taken regarding the benefits and drawbacks of this type of arrangement before entering it.
Is there a limit on the size of my pension funds?
The simple answer is no, but if the total value of all your pension funds exceeds the lifetime allowance, which is currently £1,073,100*, then your fund will be subject to a lifetime allowance tax charge on the excess amount.
The excess can either be taken as a lump sum after the deduction of 55% of the excess as a tax charge or as taxable income following the deduction of 25% of the excess as a tax charge. Advice should be taken if your pension funds are approaching or exceed the lifetime allowance prior to any pension benefits to be drawn to ensure they are structured in the most appropriate way.
*Some people will have a higher level of lifetime allowance due to having the benefit of one of several transitional protections. Again, it is very important that advice is obtained before drawing any benefits.
The information contained within this article is for guidance only and is based on our current understanding of UK pension tax legislation. It does not constitute advice which should always be obtained when considering pension benefits.
DSW Wealth Planning is a trading name of Dow Schofield Watts Wealth Planning LLP which is an appointed representative of Corbel Partners Limited which is authorised and regulated by the Financial Conduct Authority.
Dow Schofield Watts Wealth Planning LLP is Registered in England and Wales. Registered Number: OC441562. Registered Office: 7400 Daresbury Park, Warrington, WA4 4BS.