One of the biggest advantages of pension saving is that you can benefit from tax relief on pension contributions.
All the money you pay into a pension qualifies for tax relief, providing an instant boost to your savings and helping the fund to grow faster than other kinds of investment.
If you’re wondering if you pay tax on pension contributions, this article will explain what you need to know.
What is pension tax relief?
To encourage saving for retirement, the government pays tax relief on pension contributions.
This means that your pension provider can claim tax back from HMRC and add that amount to each contribution you make.
From your point of view, it’s like receiving a bonus on everything you save.
How does tax relief work?
You can get tax relief on your pension contributions in two key ways, which are ‘relief at source’ and ‘net pay.’
Relief at source
If you have a personal pension, you’ll always get tax relief through relief at source.
With relief at source, your employer takes away tax from your salary and then deducts your pension contribution from your after-tax pay, which is sent to your pension provider.
Your pension provider claims the basic 20% rate of tax relief from the government before putting it into your pension.
If you’re a higher or additional rate taxpayer, you’ll have to claim extra tax relief from HMRC.
Self-employed? You would need to make a contribution to your pension provider.
Unlike relief at source, your pension contribution is taken before you are taxed, so you’ll end up paying less tax.
This also means you get tax relief immediately and don’t have to claim any relief back.
One downside of net pay is that if you don’t pay tax, you won’t receive any tax relief.
Do I get tax relief if I don’t pay any tax?
If you don’t pay tax, whether or not you get tax relief on your pension contributions depends on whether your employer uses the relief at source or net pay method.
With the net pay method, if you don’t pay tax, you can’t get tax relief.
You should get tax relief with relief at source if you don’t pay in more than your UK earnings.
If your employer doesn’t have a workplace pension scheme, it’s worth asking them if they can set one up.
Tax relief - how is it calculated?
You’ll receive tax relief at the highest rate of income tax that you pay. If you’re a basic rate taxpayer, you’ll get 20% tax relief.
This means that every pound you pay in becomes £1.25 (because £1.25 taxed at 20% would become £1).
In other words, receiving 20% tax relief is the equivalent of having a 25% boost to every contribution you make into your pension.
This is one of the biggest reasons why pensions are so hard to beat as an investment.
Tax relief on pension contributions for high earners
If you’re a higher-rate taxpayer, you’ll get 40%. This means that every pound becomes around £1.66 – the equivalent of a 66% boost.
Additional rate taxpayers get 45% tax relief (effectively around an 80% boost!).
However, this additional tax relief isn’t delivered automatically.
The basic 20% tax relief will be added to each contribution, but if you’re a higher or additional rate taxpayer you’ll have to claim back your extra tax relief via your tax return.
What if I don’t have an income at the moment?
If you’re not working or earning below £3,600 a year, you can still contribute to a pension – for example, if you transfer some savings or a partner contributes on your behalf – and get tax relief.
However, you’ll only receive tax relief on contributions of up to £2,880 every year.
You can pay in more if you wish, but any extra contributions will not receive tax relief.
Do pension contributions reduce your taxable income?
The answer to this is both yes and no.
Pension contributions are free of income tax, so in that sense, the answer is yes.
But does making pension contributions cut your taxable income for the purposes of income tax bands?
Well, if you are making pension contributions out of your earnings, the answer is no.
If you earn over £50,270 a year, you will be considered a higher rate income tax payer, but you can claim back higher-rate tax relief on pension contributions above that threshold.
However, there is a way to actually reduce your taxable income with pension contributions.
You can do this using a salary sacrifice scheme.
With this scheme, your employer agrees to make additional pension contributions on your behalf in exchange for reducing your salary by a certain amount.
This means you pay less income tax and national insurance, so you can potentially get a higher pension contribution than you could have afforded from your salary.
It can also have the effect of reducing your salary to a lower tax band. It’s worth asking your employer if they offer a salary sacrifice scheme.
A financial adviser can help you make the best decision for your circumstances.
How much can I pay into a pension and get tax relief?
It’s important to know how much you can pay into a pension and still receive tax relief.
You can get tax relief on up to 100% of your annual earnings (a maximum of £60,000) although this doesn’t apply to contributions from your employer.
Also, you have an annual allowance where you can contribute up to £60,000 into your pensions in a tax year, but this may be lower for some people, so it’s worth checking.
If you exceed this limit, you may have to pay an additional tax charge.
There was also a limit to the total size of all your pension pots, known as the lifetime allowance, but this was recently removed for this tax year and will be scrapped from April 2024.
Why is pension tax relief so important?
Tax relief on pension contributions is vital when it comes to saving for retirement.
Quite simply, the more you and your employer pay in, the more you receive back from the government.
At the same time, it’s crucial to understand your allowances and limits so that you don’t contribute too much and end up paying tax charges.
Unbiased can connect you to a local financial adviser who can look at your circumstances and make sure you’re receiving all the pension tax relief you’re entitled to and avoid a hefty tax bill.