When it comes to managing money, one of the things people find most difficult to understand is the tax relief they get on payments into their pension. This is perhaps not surprising, because tax relief is given in one of three different ways:
1. Relief at source method
This is the method of giving tax relief on personal payments used by ‘contract-based’ pensions such as personal pensions, group personal pensions and stakeholder pensions. Some occupational pensions, including the government’s workplace pension scheme, Nest, also use this method.
The relief at source method deducts personal pension payments from income after income tax has already been calculated. However, when the payment reaches your pension, it is ‘grossed up’ to account for the basic rate of tax relief.
This is how it works:
This is good for basic rate taxpayers and, especially non-taxpayers, who get basic rate tax relief automatically at 20%.
Higher rate taxpayers and relief at source
People who pay higher rate tax (annual income roughly £43,000 or more) usually claim additional tax relief through their self-assessment tax return. The relief at source method only provides up-front tax relief at 20%, so if you pay a higher rate of income tax, you have to claim back the difference.
Most higher rate taxpayers didn’t traditionally submit self-assessment returns, although the number doing so has increased in recent years due to the introduction of the child benefit charge for those earning above £50,000.
This has meant that some higher rate taxpayers failed to claim back the tax relief due to them.
If you don’t fill in a self-assessment return you can still claim the extra 20% tax relief by speaking with, or writing to, Her Majesty’s Revenue and Customs (HMRC).
If you find out that you haven’t been claiming the tax relief you are due, you are entitled to claim back tax relief from the previous four tax years as well as the current tax year. For example, if you were submitting a claim today (in the 2016/17 tax year), you can go back as far as tax year 2012/13.
2. The net pay method
This is the method used by most occupational pension schemes to give you tax relief on your payments.
This method deducts employee contributions from gross pay before tax is calculated, meaning that you automatically (and immediately) get tax relief on your pension payments at your highest marginal rate of income tax.
While this may sound like a good thing, it doesn’t work well for people who earn below their personal allowance (standard personal allowance in 2016/17 is £11,000). Because they don’t pay tax, deducting the pension contribution from their gross pay doesn’t reduce the amount of tax they pay. Non-taxpayers therefore get no tax relief on personal payments into net pay schemes – whereas they automatically receive 20% tax relief by using the ‘relief at source’ method (see above).
You will recognise a private sector occupational pension scheme as it usually has a board of trustees who have a legal duty to help you manage your pension in your best interests.
Does this apply to defined benefit or defined contribution schemes?
The net pay method applies to all defined benefit schemes and most defined contribution occupational schemes.
All private sector defined benefit (‘final salary’ or ‘average salary’) schemes are set up as occupational pension schemes, and all of them use the net pay method of giving tax relief on employee contributions.
Government statutory pension schemes, like the NHS, teachers and civil service pension schemes don’t have trustees, as they are established by their own acts of parliament. However, they operate as occupational pension schemes, and also use the net pay method of giving tax relief on employee payments.
Some private sector defined contribution pension schemes are occupational pensions. Common names for these schemes include ‘group money purchase schemes’, ‘master trusts’ and ‘executive pensions’.
3. Salary sacrifice or salary exchange
Many people, particularly those who work for large employers, now make payments into their pension by a method known as ‘salary sacrifice’ or ‘salary exchange’.
This entails giving up part of your salary in exchange for an extra payment into your pension from your employer.
By giving up the top slice of your income, you have effectively received income tax relief at your highest rate.
Salary sacrifice also reduces the National Insurance (NI) contributions you pay:
- If you earn between £8,060 and £43,004 a year, NI contributions are reduced by 12% of the amount you’ve given up through salary sacrifice.
- If your income is above £43,004, your National Insurance contributions are reduced by 2% of the amount of income given up.
There’s good news for your employer, too. They save on employer’s National Insurance contributions. Some employers retain the amount they save to cover the costs of administration for the salary sacrifice arrangement, while others share the saving with employees by paying in even more into their pensions.
Salary sacrifice is the most efficient way for most employees to receive tax relief, because you automatically get income tax relief at your highest marginal rate, and you pay reduced National Insurance contributions.
However, like the net pay method of giving tax relief, salary sacrifice doesn’t work well for those whose annual income is less than their personal allowance or where the sacrifice of salary takes them below that level (£11,000 in 2016/17). If you earn below your personal allowance, giving up salary doesn’t reduce the tax you pay because you don’t pay any tax in the first place.
A few other points about salary sacrifice:
You are required to contractually agree to reduce the income you receive.
A reduced income could have implications for state benefits you receive. This could be favourable or unfavourable. For example, reducing your income may increase the amount of child tax credit you receive or reduce the child benefit charge you pay. However, if your income reduces below the lower earnings limit (£5,824 in 2016/17) you could lose entitlement to benefits such as state pension and statutory maternity pay. Check the overall impact of salary sacrifice, particularly on your entitlement to state benefits, before you agree to go ahead.
A reduced income could affect the amount you are allowed to borrow. Most lenders will take into account your salary before the sacrifice took place, when calculating the amount you are allowed to borrow, but some lenders don’t.
Salary sacrifice is optional, so you don’t have to agree to make your pension payments this way. People whose income is around the level of their personal allowance or less should think twice before agreeing to salary sacrifice.
If a salary sacrifice takes your income below the minimum wage, then the sacrifice will not be allowed. This is because minimum wage law states that you must receive the minimum wage as cash rather than as part cash and part pension.
More pension tax relief pointers for higher earners
We’ve mentioned the need to claim back higher rate tax relief if you make personal payments into your pension using the relief at source method of giving tax relief. However, there are a few other things that high earners (or those making large payments into their pension) need to consider:
Pension contributions, regardless of the method used to claim tax relief, have the effect of reducing your income by the gross amount of the pension contribution. This means that if your annual income is between £100,000 and £122,000, a pension contribution will allow you to reclaim some of your personal allowance as well as pension tax relief. Similarly, those with children who earn more than £60,000 may be able to reduce their child benefit charge if their gross pension contribution has the effect of reducing their taxable income below this level. Therefore, the ‘effective’ rate of tax relief on a payment into your pension can often be much higher than 40%, when you consider the whole effect of the pension payment.
The Annual Allowance of £40,000. This limits the amount of tax relief that you can get in any one tax year and is based on the combined total of employee and employer payments into your pension.
Carry forward. If you don’t use your full Annual Allowance in a tax year, you can carry the unused balance forward for up to three tax years. This could allow you to pay in more than £40,000 and qualify for tax relief (up to a theoretical maximum of £170,000, representing three years of £40,000 and one year where the limit was £50,000).
If you draw income from your pension at age 55, your Annual Allowance reduces to £10,000. You are allowed to draw your tax-free lump sum without affecting your Annual Allowance but as soon as you draw even £1 of taxable income from your pension, your Annual Allowance will reduce. The one exception to this rule is people who were already drawing their pension before 6 April 2015 using ‘capped drawdown’, which only permits income to be taken from your pension up to a certain limit. Capped drawdown is not available for those who start to draw their pension for the first time after 5 April 2015.
The Lifetime Allowance. You are allowed to build up a £1m pension fund in a defined contribution plan or a £50,000 annual pension income in a defined benefit plan, before you face a tax surcharge on your pension at retirement. Defined benefit pension income above £50,000 receives a surcharge of 25% before it is then taxed at your highest marginal rate of income tax. Any fund in a defined contribution pension above £1m can either be taken as a cash lump sum subject to tax at 55% or alternatively, kept in the pension fund and subject to a lifetime allowance charge of 25% on the excess over £1m. If using the latter option, any subsequent withdrawals from the pension are subject to income tax at your highest marginal rate.
In some circumstances you might be entitled to a higher lifetime allowance than the standard amount. This will be because you have applied for one of the protections that were available when the Lifetime Allowance was first introduced on April 2006 or when the Lifetime Allowance has been reduced in recent years. The original ones were called ‘enhanced protection' and 'primary protection' and the more recent ones are called 'fixed protection' and 'individual protection'.
Paying into someone else’s pension
It’s possible to pay into someone else’s pension on their behalf, for example your spouse, partner or children.
These payments are called ‘third party contributions’ and the rate of tax relief received is that which is applicable to the recipient of the pension payment.
For example, if you are a 40% tax payer and you are paying money into your spouse’s pension (who only pays tax at 20%) then the rate of tax relief will be 20%.
It’s also possible to make pension payments on behalf of non-earners such as children. Up to £3,600 (£2,880 net of tax relief) can be paid into a pension each tax year on behalf of a non-earner.
If the payment is made into a pension (such as a personal pension) which uses the relief at source method of giving tax relief, then the recipient also qualifies for 20% tax relief – even if they don’t pay tax.