With the introduction of ‘auto-enrolment’, more and more people are compulsorily required to save towards a personal pension. However, not everyone is aware that they can claim tax relief on these personal (employee) pension contributions!
What is pension tax relief and who can get it?
When you save into a pension, the government usually gives you a top up as a way of encouraging you to save for your future. This top up comes in the form of tax relief.
Tax relief is only given on pension contributions if:
- You are under age 75,
- You are UK resident, and
You make a gross contribution of up to the higher of (a) your UK relevant earnings or (b) £3,600 gross (which is £2,880 as a net contribution to your pension – that is, the amount you pay in).
All pension contributions paid by a member, a third party on their behalf and by their employer are also tested against the member’s annual allowance. The value of any defined benefit accrued during the tax year is also tested. The standard annual allowance is currently £40,000.
If the total exceeds their annual allowance for the tax year (taking into account any unused annual allowance carried forward), they will still be able to claim higher rate and additional rate tax relief on their pension contributions, but an annual allowance charge will apply to the excess above the annual allowance.
Normally, you get basic tax relief automatically as your pension provider will claim the tax relief for you and add it to your pension pot (‘relief at source’), which I’ll explain below.
How much Tax Relief do I get?
Tax relief is available on your pension contributions at the highest rate of income tax that you pay. So, for non-Scottish taxpayers, this means:
- Non-taxpayers (that is, people who earn under the personal allowance) get no pension tax relief – unless they are in a ‘relief at source’ scheme
- Basic-rate taxpayers get 20% pension tax relief
- Higher-rate taxpayers get 40% pension tax relief
- Additional-rate taxpayers get 45% pension tax relief
The way pension tax relief works differs depending on what kind of pension scheme you are in:
- If you are in a ‘net pay’ arrangement, the employee pension contribution is deducted before tax is calculated on your pay (meaning you receive tax relief there and then).
- If you are in a ‘relief at source’ arrangement, the employee pension contribution is deducted after tax is calculated and HM Revenue & Customs (HMRC) later send the value of the tax relief to the pension scheme.
What this means is that under ‘relief at source’, if you earn £50,000 but made an employee pension contribution of £4,000, your pension fund will claim 20% tax relief on your gross contribution of £5,000, meaning you get an extra £1,000 in your pension pot from the HMRC. Free money, some may say, or an immediate 25% return on your investment! Not a bad incentive to save for your retirement, isn’t it?
Note in the above example, if you were under a ‘net pay’ arrangement, a £4,000 contribution would lead to a £1,000 reduction in PAYE income tax as you will be only taxed on income of £46,000, and so you would have that £1,000 in your pocket, rather than in your pension pot.
Pension tax relief for low earners: what problems might arise?
If you are a low earner (that is, if you earn below or only just above the personal allowance – £12,500 in 2020/21), you may wish to check which type of pension scheme you are in. If you are in a ‘relief at source’ arrangement, the pension provider claims 20p basic tax relief back from HMRC for every 80p of your contribution received – no matter what the level of your earnings.
If you earn say £5,000 in the 2020/21 tax year, you can make a gross contribution of up to £5,000 into that pension. This equates to a net contribution of £4,000, because the pension scheme will claim tax relief of £1,000. If you earn less than £3,600, you are limited to tax relief on a gross contribution of £3,600 (£2,880 net). In either case, the fact that you do not pay any income tax does not prevent the pension scheme claiming the tax relief.
However, if you are in a ‘net pay’ arrangement, you will not get any tax relief. Some people thing this is unfair and are lobbying the government to change the rules
How is Higher-rate Tax Relief calculated?
For those earning more than the basic rate of income tax, it gets even better.
Higher rate taxpayers may be entitled to further tax relief on personal contributions paid into their pension scheme. As the pension scheme provider gives basic rate tax relief at source, the member claims any higher rate and additional rate tax relief from HMRC. The extra tax relief available depends on the total personal contributions paid and the member’s total income.
The extra tax relief due is given by extending the basic rate tax band. The following example shows how this works.
Steve’s gross income is £100,000. His personal allowance is £12,500, which means he has taxable income of £87,500. He makes a net pension contribution of £32,000 to his pension provider and basic rate tax relief of £8,000 is added, resulting in £40,000 being added to his personal pension. The following table shows that he can claim a further £8,000 higher rate tax relief:
| Tax payable assuming no pension contribution | Tax payable assuming £40,000 gross pension contribution | |||
|---|---|---|---|---|
| Tax rate | Tax band | Tax | Tax band | Tax |
| 0% | £12,500 | £0 | £12,500 | £0 |
| 20% | £37,500 | £7,500 | £37,500 | £7,500 |
| 20% extension | N/A | £40,000 | £8,000 | |
| 40% | £50,000 | £20,000 | £10,000 | £4,000 |
| Total tax | £27,500 | £19,500 | ||
The difference between the total tax figures is £8,000 and this is the higher rate tax relief that Steve can claim back from HMRC. The total tax relief of £16,000 is 40% of the gross contribution of £40,000. That’s an amazing 50% extra on top of a £32,000 contribution!
Note that higher rate tax relief is only available to the extent that higher rate tax is due to be paid.
For additional-rate taxpayers, the situation is similar to the above except that the 40% band is also extended by the amount of the gross pension contribution, resulting in an additional 5% tax relief.
The above applies to ‘relief at source’. For ‘net pay’ arrangements, your pension contributions are deducted from your salary by your employer before income tax is calculated on it, so you get relief on the amount immediately at your highest rate of tax.
How Is Higher-Rate Tax Relief Claimed?
There are two ways for higher rate tax relief to be claimed on a personal contribution to a pension scheme:
1. Through the annual self-assessment tax return
Higher rate tax relief can be claimed by entering the amount of gross personal contributions made to a personal pension scheme in the relevant part of the annual self-assessment form (including any contributions made by a third party). Employer contributions should not be included in this amount. Tax relief is given in one of three ways:
- a change to the tax code.
- a tax rebate.
- a reduction in tax already due to HMRC.
2. By notifying the local tax office
People who don’t usually fill in an annual self-assessment form, or who don’t want to wait for their higher rate tax relief, can phone or write to their local tax office with details of:
- the personal pension scheme that personal contributions are being paid to,
- the date that the contributions start, and
- the gross amount of the personal contributions paid.
The local tax office will then arrange for their tax code to be changed so that higher rate relief is available throughout the year in which the contributions are being made. Any changes to the information given can be notified either by letter or through a self-assessment tax return at the end of the tax year.
Top tips and Tax Traps
If you’re employed in a limited company, the employer contributions are a deductible business expense (not the employees contributions, which are deducted from their net pay).
As an employee, you can only get tax relief for your personal (employee) pension contributions, you cannot get personal tax relief for any employer contributions – so these must be excluded from the self assessment tax return!
NB: There is a time limit of four years to claim back any tax relief from HMRC. A claim must be made within four years of the end of the tax year that a member is claiming for.
What action do I take now?
Speak to your financial or tax advisor if you want to make a contribution to take advantage of pension tax relief before the end of the tax year. There have been suggestions that the chancellor may look to reduce the current level of pension tax relief for higher rate taxpayers, so now is the perfect time to top up your pension pot.
If you normally have to lodge a self assessment tax return haven’t filled in your 2019/20 return and you earned more than £50,000 in income – check your pension scheme records to see if you made any personal pension contributions in a ‘relief at source’ arrangement and make sure you include the gross contribution (your net contribution + 20% basic tax relief) in the relevant part of your self assessment return. Also if you haven’t claimed it in the past by mistake – remember you can go back and claim up to 4 years!
Or if you don’t need to fill in an annual self-assessment form, get in touch with your local tax office to change your tax code.
Pension tax relief is treated by HMRC as ‘claim it or lose it’. They won’t tell you that you’re due money back, so it’s up to you the taxpayer to make sure you claim it.
If you need a hand filling in your tax returns – mrtaxman can help with SA tax return preparation from only £99. Or book an appointment for a tax planning session to speak to us about how you can use pension tax relief to its maximum benefit. Contact mrtaxman on 07726 424330 or email [email protected].