When paying into pensions, individuals receive income tax relief on any contributions they make at the highest rate of income tax they pay (known as the marginal rate), provided the total gross pension contributions paid into their pension schemes (including contributions paid by employers and other people, as well as the individual’s own contributions) don’t exceed the lower of:
Their annual earnings; and
The annual allowance (see section below).
If an individual doesn’t have any earnings (for example, if they don’t work) or earn less than £3,600 each year, they can make gross contributions of up to £3,600 (£2,880 net) each year to a personal pension, self-invested personal pension (SIPP), or stakeholder pension receiving basic rate income tax relief at 20% on their contributions. Individuals can pay in higher amounts than their maximum limit, but don't receive tax relief on the excess amounts.
How are pension contributions actually paid?
Pension contributions can be paid either through a workplace pension scheme, essentially as part of an employment, or by making personal pension contributions outside of an employment.
Workplace pension schemes
Individuals can obtain tax relief in 3 different ways on their contributions, depending on the type of scheme.
The employer deducts contributions from the employee’s pay before it is subject to tax – the net pay arrangement.
The employer deducts contributions from the employee’s net pay – the relief at source arrangement.
Pension contributions are deducted through a salary sacrifice arrangement.
The net pay arrangement
Under the net pay arrangement, the employer deducts contributions from the employee’s pay before it is subject to tax, meaning that tax relief is received at the highest rate of tax (the marginal rate).
The relief at source arrangement
Under the relief at source arrangement, the employer deducts contributions from the employee’s net pay. The pension provider then claims back basic rate tax relief at 20% and adds this to the pension pot. If an individual is a higher or additional rate taxpayer, they need to claim back the extra tax relief at their marginal rate, usually through their tax return.
The salary sacrifice arrangement
When pension contributions are paid through a salary sacrifice arrangement agreed with an employer, this is treated as an employer contribution, with the same effect for the individual as receiving tax relief as above under a net pay arrangement but also with a saving on National Insurance Contributions.
Personal pension contributions
If an individual has set up their own scheme (such as a personal pension, self-invested personal pension or a stakeholder pension scheme), the contributions that are paid into the scheme are usually treated as being paid net of basic rate income tax relief, in much the same way as a relief at source workplace pension.
The pension provider claims back basic rate tax relief at 20% and adds this to the pension pot. If an individual is a higher or additional rate taxpayer, they need to claim back the extra tax relief at their marginal rate, usually through their tax return.
The annual allowance
The annual allowance is a limit to the total amount of contributions that can be paid to defined contribution pension schemes, and the total amount of benefits that can be built up in defined benefit pension schemes each year, for tax relief purposes.
The annual allowance is currently capped at £40,000 although this is subject to a further restriction for high earners (see the tapered annual allowance section below). A lower limit of £4,000 may apply where individuals have already started accessing their pensions (see the money purchase annual allowance section below).
The annual allowance applies across all of the schemes an individual belongs to; it’s not a ‘per scheme’ limit and includes all of the contributions that the individual pays, their employer pays or anyone else who pays on their behalf.
Where the annual allowance is exceeded in a year, the individual won't receive tax relief on any contributions paid that exceed the limit and will be faced with an annual allowance charge.
The available annual allowance for the current year is increased by any unused annual allowance from the previous 3 years (but this does not apply to the money purchase annual allowance).
The tapered annual allowance
The tapered annual allowance came into force from April 2016 for high earners. For every £2 of ‘adjusted income’ (essentially an individual’s net income, plus pension contributions made by them and/or their employer) above £150,000 per annum, £1 of annual allowance will be lost. The maximum reduction will be £30,000 meaning that individuals earning over £210,000 will have their annual allowance capped at £10,000.
Where an individual’s ‘threshold income’ (generally an individual’s net income, less the gross amount of any personal pension contributions) is under £110,000, the tapering above will not be applied, even if their adjusted income is over £150,000.
The money purchase annual allowance
If an individual has taken flexible benefits from their pension and they want to continue to make contributions, they will have a reduced annual allowance of £4,000 towards their defined contribution benefits. The reduced allowance will apply where individuals have withdrawn more than the 25% tax free pension commencement lump sum.
The reduced allowance includes both individuals’ own contributions and any other contributions paid on their behalf, such as an employer or a third party.
Conclusion and recent update
As you can see from this brief introduction to pension contributions, the current rules are very complicated and as is so often the way, the devil is in the detail. In the right circumstances and with specialist advice, however, pension contributions can attract up to 60% tax relief.
The Treasury has recently announced it will review the tapered annual allowance for pensions for individuals in the public sector, following calls from high-earning NHS clinicians to abolish it. There are also wider calls for the taper relief to be abolished all together, even if this means a slightly lower allowance across the board.
Please contact us to find out how the above applies in your circumstances and how you can reduce your tax liabilities and maximise your tax efficiency.
Please note that the above is for general information only and does not constitute financial or tax advice. You should not rely on this information to make or refrain from making any decisions. You should always obtain independent professional advice in respect of your own situation.