Tax Relief on Pension Contributions Explained

05/02/2022 - 8 minutes read

Do you want to know more about the tax relief on pension contributions?  If yes, read this article to see how you can maximise tax efficiency by contributing to a pension scheme.

Tax Relief on Pension Contributions Explained

Tax Relief on Pension Contributions

Tax relief on pension contributions

You can get tax relief on pension contributions worth up to 100% of your annual earnings.

You get the tax relief automatically if your:

  • – employer takes workplace pension contributions out of your pay before deducting Income Tax
  • rate of Income Tax is 20% – your pension provider will claim it as tax relief on pension contributions and add it to your pension pot (‘relief at source’)

It’s up to you to make sure you’re not getting tax relief on pension contributions worth more than 100% of your annual earnings. HM Revenue and Customs (HMRC) can ask you to pay back anything over this limit.

It is granted automatically at 20% of the amount going into your pension, while higher rate taxpayers can claim back an extra 20% and additional rate taxpayers 25% tax relief on pension contributions, whether that is through their annual self-assessment tax return or automatically in their workplace pension.

If you pay £80 into a self-invested personal pension (SIPP) or workplace pension, that will be topped up to £100 whatever your marginal (or top) tax rate. Because £20 is the tax that a basic ratepayer would pay on £100, it’s worth noting that your pot is boosted by 25% by the 20% tax relief (£20 being a quarter of £80).

A higher rate (40%) taxpayer could then claim back another £20, while an additional rate (45%) taxpayer could claim £25. The higher rate taxpayer is getting £100 in their pension pot for a net cost of £60 after the tax reliefs. That is effectively a 66.7% return before any investment growth.

Workplace schemes vary in how they administer this, so some higher rate taxpayers in company pensions and the majority of SIPP holders will have to take steps to claim back their extra tax relief.

Tax relief on pension contributions

Tax relief on pension contributions based on £100 gross contribution

If your pension scheme is not set up for automatic tax relief on pension contributions

Claim tax relief in your Self Assessment tax return if your pension scheme is not set up for automatic tax relief on pension contributions.

Call or write to HMRC if you do not fill in a tax return.

You cannot claim tax relief if your pension scheme is not registered with HMRC.

At some companies, the tax benefits could be even greater as they may allow employees to reduce salary or bonus payments in lieu of increased pension contributions.

‘Salary sacrifice’ entails the employee agreeing to a lower gross income and the employer paying the difference into a pension alongside their usual contributions. Both employee and employer will as a result pay lower National Insurance contributions (NICs), which are set to rise in April, and this makes pension saving, even more, tax efficient.

Sometimes the employer might even pay some or all of their NIC saving into your pension.

Pension allowances

Savers who are able to lock away their money until the minimum pension access age (currently 55) need to seriously consider the fiscal advantages detailed above. But there are ceilings on what can be saved tax-free.

For most people, the total sum of personal contributions, employer contributions and government tax relief received cannot exceed the annual personal allowance of £40,000 (2021/22). More rigid and complicated rules apply for the very highest earners under a tapering allowance that can reduce the annual allowance to as little as £10,000.

You can’t contribute more than 100% of your earnings to a pension during the tax year, so if your salary is lower than £40,000 then you are limited to contributing your annual earnings into pensions.

The lifetime allowance (LTA) is the limit on how much you can build up in pension benefits over your lifetime while still enjoying the full tax benefits. Exceeding the standard LTA of £1,073,100 (as of 2021/22 – and frozen at that level until 2025/26), will lead to additional tax charges on the excess when you come to take your pension benefits or turn 75.

Carry forward unused pension allowances to obtain Tax relief on pension contributions

The pension annual allowance was £255,000 in 2010/11: as it is now £40,000, it is affecting a lot more savers than it used to.

Pensions ‘carry forward’ rules allow you to use unused allowances from up to the three prior tax years in the current tax year – provided you have already maximised your current annual allowance and were a member of a pension scheme in the tax year you are carrying forward from.

Notionally, you could potentially carry forward up to £120,000 of unused allowances and add them to this year’s £40,000 allowance. Tax relief would be applied at your current marginal rate and so carry forward can be particularly attractive to someone whose earnings have risen significantly.

Hidden tax risks of raiding the pension pot

The major drawback of pensions for some savers is that the money is locked away once committed. But up to 25% of your pot can be accessed tax free – with the remaining 75% available as taxable income – from the private pension access age. That is currently 55 but set to rise to 57 from 2028.

This is certainly not to say that this is the right thing to do. But for savers aged 50 and over, the limits on access become less meaningful compared to the monetary benefits of saving into a pension.

Anyone who makes a flexible withdrawal from their retirement pot beyond the 25% tax-free lump sum triggers the money purchase annual allowance (MPAA). This permanently slashes their annual allowance from £40,000 to just £4,000 and revokes the privilege to carry forward unused allowances from previous tax years.

We cover this in a separate article here.

How can MCL Accountants help?

Contact MCL Accountants on 01702 593 029 if you have any queries about Tax relief on pension contributions or if you need any assistance with the preparation and submission of your business accounts or self-assessment tax returns to HMRC.