One of the key benefits of pension saving is the ability to get upfront ‘tax relief’ on your contributions. Tax relief just means that your contributions are free from income tax.

The amount of tax relief you are entitled to will depend on the income tax band your pension contribution comes from. A basic-rate taxpayer paying 20% tax will therefore be entitled to 20% tax relief, a 40% taxpayer 40% tax relief and a 45% taxpayer 45% tax relief.

If you live in Scotland, you might be subject to different income tax rates and therefore be entitled to different amounts of pension tax relief.

100% OF EARNINGS LIMIT

The amount you can personally contribute to a pension annually and receive tax relief is limited to 100% of your ‘relevant earnings’. So, if you have total relevant earnings of £15,000, the maximum personal contribution you can make, including tax relief, is £15,000.

If you don’t earn an income, you are still entitled to tax relief at the basic rate (20%), although the maximum you can pay in each tax year (inclusive of tax relief) is £3,600.

There is also an overall ‘annual allowance’ which limits the total amount that can be paid tax efficiently into a pension each year. This annual allowance covers personal contributions, employer contributions and tax relief.

The annual allowance in 2022/23 is set at £40,000. If you breach the annual allowance, an annual allowance charge will be applied which aims to claw back the upfront tax relief you have received.

If you have flexibly accessed taxable income from your pension – either through drawdown or by taking an ad-hoc lump sum – you will be subject to the ‘money purchase annual allowance’ (MPAA). This reduces your annual allowance from £40,000 to just £4,000 and removes your ability to ‘carry forward’ any unused annual allowance from the three previous tax years.

In addition, if you are a very high earner you may be subject to the ‘taper’, which can reduce your annual allowance from £40,000 to as low as £4,000. If you are affected by the taper, your actual annual allowance will depend on your earnings. You can read more about how this works here.

There is also an overall ‘lifetime allowance’ which in 2022/23 is set at £1,073,100 – although some may have locked into a higher lifetime allowance by claiming a form of ‘protection’. If you breach your lifetime allowance, you will be hit with a lifetime allowance charge.

You can read more about how the lifetime allowance works here. 

Example: Emma has an annual income of £60,000 and makes a pension contribution of £20,000 to a SIPP, which pays tax relief at source.  She receives basic-rate tax relief upfront, meaning the £20,000 contribution is increased to £25,000 in her pension.

She is also entitled to claim higher-rate relief on the portion of her contribution that was in the higher-rate tax bracket. In 2022/23, the higher-rate tax band kicks in at £50,270, meaning Emma can claim higher-rate relief on the slice of her contribution above £50,270, which is £9,730.

She can therefore claim an extra £2,432.40 in higher-rate relief on this part of her contribution, alongside the £5,000 basic-rate relief she has already had paid into her pension automatically. The higher-rate relief will be paid via an adjustment of her tax code in the following tax year (2023/24).

HOW TO CLAIM PENSION TAX RELIEF

There are different types of pensions which claim tax relief in different ways. If you are contributing to a ‘relief at source’ pension scheme, such as a SIPP, then basic-rate tax relief will be added automatically. This means if you pay in £80, it will be topped up immediately to £100 via basic-rate tax relief.

If you pay tax at a higher rate than basic and are contributing to a relief at source scheme, you can claim back further tax relief via your tax return. In the case of the above example of an £80 contribution, a higher-rate taxpayer could claim an extra £20, and an additional-rate taxpayer an extra £25.

While basic-rate relief will be paid into your pension, any higher or additional-rate relief you claim back will usually be paid via an adjustment of your tax code the following year.

If you are contributing to a ‘net pay’ pension scheme, you will usually be granted all of your tax relief automatically. This is because your contributions come out of your gross salary before any income tax has been calculated. It’s important to note that National Insurance will be deducted from your salary before your pension contribution is taken.

However, low earners risk missing out on pension tax relief if they contribute to a net pay scheme. This is because if you are a 0% taxpayer (i.e. earning below the £12,570 personal allowance) then the design of a net pay scheme means you will receive 0% tax relief.

The Government has committed to implementing a solution to this so-called ‘net pay anomaly’, but this won’t be in place for a number of years.

Example: Charles earns £20,000 a year and makes a £2,000 contribution to his workplace pension scheme, which pays tax relief on a ‘net pay’ basis. Because this contribution is taken from his pay before income tax has been calculated and Charles is a basic-rate taxpayer, he has received his tax relief – worth £400 – automatically.

You can also pay pension contributions via something known as ‘salary sacrifice’. This, as the name indicates, involves giving up a portion of your salary, with your employer instead paying you a ‘non-cash benefit’ – in this case pension contributions.

This will mean you get your pension tax relief upfront, while also reducing employee and employer National Insurance contributions.

One thing to bear in mind when considering salary sacrifice is the impact it might have if you are ever made redundant. As your salary will be reduced, it is possible your redundancy entitlement will be reduced too. Taking less salary could also affect things like maternity/paternity pay, mortgage applications and some state allowances.

Example: Natasha earns £30,000 a year and enters a salary sacrifice arrangement with her employer. Natasha’s salary will be reduced to £27,000 as a result, with her employer paying £3,000 into a pension scheme on her behalf.
Tax relief has been added automatically.

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