Tax relief is one of the biggest attractions of saving in a pension. As it celebrates its 100th anniversary in 2021, we explain what pension tax relief is and what’s in it for you.
The concept of pensions tax relief was first introduced in the Finance Act of 1921. Then, as now, it’s an incentive to save today for our retirement tomorrow. In short, it means money that would have otherwise been paid as tax instead supports your pension.
And it’s a big boost. It’s estimated that the government foregoes approximately £40 billion every year by allowing this money to be channelled towards supporting employer and employee pension contributions 1.
Of course, tax rules are subject to change and depend on your personal circumstances. The tax relief you get on what you pay into your pension depends on a few things: the type of pension; how much you pay in; your highest marginal rate of income tax; and where in the UK you live.
What does it mean for you?
The figures here are based on 2021/22 tax rates if you live in England, Wales or Northern Ireland (tax rates in Scotland are slightly different, but the same principles apply). They also assume you have a ‘defined contribution’ pension, that is, its value depends on how much is paid into it, how its investments perform, and the charges that apply.
If you’re a basic rate taxpayer, you’ll get tax relief of 20% on your pension contributions. This means that every £100 you pay into your pension is actually made up of just £80 from you and £20 tax relief.
There’s more good news if you’re a higher or additional rate taxpayer. You can claim back the extra tax relief through your self-assessment tax return.
Please note: If you have a workplace pension where contributions are made through a ‘salary sacrifice’ arrangement, it works differently. Here, you ‘sacrifice’ some of your taxable salary in return for an equivalent pension contribution from your employer. So your total pension contribution is paid in with no tax deducted. If that money had been paid to you through PAYE, it’d be subject to tax and National Insurance and would therefore be a lower amount.
Tax when you take your pension
It’s rarely possible to use your pension and to not pay tax at all on that money. When you take your pension income, it’ll be taxed like all other forms of income. You currently pay tax on income above the standard annual allowance of £12,500.
On the bright side, you’re likely to be eligible to take a tax-free lump sum from your pot first. And for some people, even if you pay a higher rate of income tax when you’re working — and therefore eligible to claim the extra tax relief — you may be a basic rate taxpayer once you’ve retired.
Know your limits
There’s a limit to the amount you can save in a pension without facing a tax charge, to keep a ceiling on how much tax relief costs the government. Most people should find this limit quite generous, though. Most people can save up to £40,000 each tax year. This is known as the annual allowance.
If you save more than £40,000 into pensions in one tax year, you may need to pay a tax charge which would effectively mean that any contributions above that amount would be ‘tax neutral’.
If you have zero earnings, or earn less than £3,600 a year, you can save up to £2,880 into pensions each year. Basic rate tax relief would take this up to a gross annual total of £3,600.
And over your lifetime, there’s also a limit on the total amount you can amass across all pensions, again to ensure a ceiling on the government’s liability. This limit is currently £1,073,100 and is called the lifetime allowance. Any pension funds above this amount may be subject to a tax charge. Please note, your State Pension entitlement is not included when working out this figure. That’s entirely separate and doesn’t affect your allowance.
Both the annual allowance and the lifetime allowance apply to total pension savings — that is, both your own savings plus any from an employer. If you’re approaching either of these allowances, it would be wise to speak to a financial adviser to help ensure any additional tax or tax charge is minimised.
If you’re already accessing your savings
If you’re 55 or over and accessing your pension savings, but still want to save into a pension as well, you need to be aware that your contributions may be subject to a much lower annual allowance, known as the money purchase annual allowance. If you’re in this situation, or think you could be in the future, it could also be a good idea to get financial advice or carry out personal research into the money purchase annual allowance.
Cheers to a valuable boost
To sum up, while pensions tax relief can get a little complicated in some scenarios, it can be a big boost on top of your savings for the future. If you don’t save in a pension you won’t receive a boost like this from other investments. So, don’t forget to factor in tax relief when you think about the value of your pension to you. And then, don’t forget to raise a glass on its 100th birthday.