While pensions are clearly an effective way to save for retirement, a benefit a lot of people overlook is the tax relief. In this article, we’ll explain how the pension tax relief works, how you can access it and how big a difference it can make over the long run.
What is pension tax relief?
Pension savings are something the government clearly wants to encourage people to have. So, when you save for your pension, the government adds a percentage to each contribution.
The portion of your savings/investments that would, under other circumstances, go towards tax now goes toward your pension as a bonus – this is pension tax relief in action.
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How does pension tax relief work?
Your pension tax relief is related to how much you earn. Essentially, you get tax relief at the highest rate of income tax that you pay. So, anyone on the basic-rate of tax will get 20% pension tax relief, while high earners will get pension tax relief of 40%. Anyone in the additional-rate bracket can get up to 45% pension tax relief.
To simplify the idea, let’s use an example. Say you wanted to put £100 a month into your pension account from your paycheck – as a basic-rate taxpayer you’d only need to pay £80 yourself, with the government topping up the rest. Higher-rate and additional-rate taxpayers would only pay £60 and £55, respectively.
These government bonuses would have been deducted in tax from your salary had you not allocated it for your pension. This is how tax relief works; the government is giving you the difference, it’s just not taking it in the form of tax.
How much can I save into my pension?
So, you want to take advantage of pension contribution tax relief. There are limits on how much you can put in in any given tax year, as well as the maximum you can put in over your lifetime.
- The annual allowance is now £60,000* per tax year.
- The lifetime allowance is currently £1,073,100.
If you don’t use your full allowance in a tax year, the rest can be carried forward for up to three years. After that, it’s lost forever.
Also, you can surpass the lifetime allowance, but taking the extra cash in retirement will be subject to hefty taxation.
There is a slightly complicated system in place for very high earners – those with a ‘threshold income’ of over £200,000 and an ‘adjusted income’ of over £260,000. Essentially, the amount you can put in per tax year reduces by £1 for every £2 you earn over the £260,000 threshold. This taper can be reduced down to a minimum of £10,000. Thankfully, the government has a helpful service to help you figure out yours.
*This is capped at your earnings. So, if you earn £25,000 a year and want to put £30,000 into your pension, you’ll only get tax relief on the first £25,000.
The two types of tax relief
This is where things get a little bit technical. There are two ways you can get tax relief on your pension contributions, and they depend a bit on your pension type. They are: relief at source and net pay.
Relief at source means that your contributions are topped up by the government. In these schemes, your contributions are deducted after tax has been deducted. However, the employer deducts only 80% of the contribution and adds an amount equal to basic rate tax relief, which it then claims back from HMRC. High earners will have to claim their extra bonus themselves.
If you use net pay, your pension contributions are taken before your pay is taxed. This can mean you pay less tax, because your earnings are reduced before the tax is applied. So, your employer will deduct your pension contribution before tax is deducted and your benefit is that you pay less in tax. With this method, the relief is immediate and you don’t have to claim anything.
Ultimately, pension tax relief can lower your tax burden and set you up for retirement at the same time. Given that retirement savings are something the government naturally wants to encourage, these benefits are generous and are something investors shouldn’t miss out on.
Important information
Capital at risk. The value of your portfolio with InvestEngine can go down as well as up and you may get back less than you invest. ETF costs also apply.
This communication is provided for general information only and should not be construed as advice. If in doubt you may wish to consult a professional adviser for guidance.
Tax treatment depends on personal circumstances and is subject to change, and past performance is not a reliable indicator of future returns.