What Is Pension Tax Relief?

Pension tax relief is money you get back from the government to bolster your retirement savings.

Ruth Jackson-Kirby Published on 25 January 2021. Last updated on 19 February 2021.
What Is Pension Tax Relief?

One of the great things about saving into a pension – apart from giving you a more comfortable retirement – is that the government pays you to do it. Read on to find out more.

What is pension tax relief?

When you pay money into your pension, the government gives you back the tax you’ve already paid on those earnings and pays it straight into your pension to boost your retirement savings. It is known as tax relief, and means some of the money that you would have given to the government goes into your pension instead.

How much tax relief you get depends on how much income tax you pay:

  • Basic-rate taxpayers pay 20% income tax, so get 20% pension tax relief.
  • Higher-rate taxpayers pay 40% income tax, so get 40% pension tax relief.
  • Additional-rate taxpayers get 45% tax relief to reflect the fact they pay 45% income tax.

This means to pay £100 into a pension it costs a basic-rate taxpayer £80, a higher-rate tax payer £60 and an additional-rate taxpayer just £55.

Income tax bands in Scotland are different, but the tax relief applied still tallies with the rate of income tax you pay. The only exception is starter-rate taxpayers who pay 19% income tax but get 20% tax relief back on their pension contributions.

How much tax relief can I claim?

At present you can claim pension tax relief on up to £40,000 or 100% of your earnings, whichever is lower. This is known as your annual allowance. Higher earners, with an income north of £240,000, get a reduced annual allowance.

How to claim pension tax relief

The way you claim your tax relief will depend on your employer. You’ll need to check with HR to see which system they use. There are two main ways pension tax relief is applied:

1. ‘Net pay’

This is used by some workplace pensions. It means that your pension contributions are taken from your salary before income tax is deducted. Your pension scheme then claims back tax relief at your highest rate of income tax on your behalf.

This means your income tax is deducted after you have paid money into your pension, and so the amount of tax you pay overall is reduced.

This is a great plus for higher- and additional-rate taxpayers, as the full amount of tax relief they are entitled to will be applied automatically, without having to deal with HMRC or complete a tax return. However, it does discriminate against lower earners who don’t earn enough to pay income tax, because they won’t get tax relief top-ups on their contributions. Following calls from campaigners, the government is currently reviewing this discrepancy.

2. Tax relief at source

This is the most common method for claiming tax relief on pension contributions and generally applies to personal pensions and SIPPs as well as some workplace pensions.

You pay income tax on your earnings as normal. You then make a contribution into your pension, so tax has already been deducted from the amount you pay in. Your pension provider then claims 20% tax relief directly from the government and it is added to your pension.

If you are a basic-rate taxpayer, you don’t need to do anything else. However, if you are a higher- or additional-rate taxpayer you need to claim the rest of the tax relief on your pension contributions yourself via HMRC.

Lower earners who don’t pay income tax will also get tax relief on their pension contributions with this arrangement.

Claiming pension tax relief if you are a high earner

If you are a higher- or additional-rate taxpayer, you may need to claim some of your pension tax relief yourself. If your pension claims tax relief at source, it will only get your basic-rate relief (20%).

A 40% taxpayer can claim the rest in two ways. If you fill in a self-assessment tax return you can claim it on your form. If you don’t fill out a tax return you can call or write to HMRC to claim your tax relief.

If you are an additional-rate taxpayer, you have to fill out a self-assessment tax return to claim your extra tax relief.

Do I get tax relief if I don’t pay income tax?

Yes. Anyone who doesn’t pay income tax, either because they don’t earn enough in their job or because they aren’t working, can claim the 20% basic tax relief on pension contributions.

The rule is you can claim tax relief on 100% of your income as long as it doesn’t exceed £40,000 a year.

The exception — as mentioned above — is if you are saving in a workplace scheme and your employer has a net pay arrangement. If you don’t have any earnings at all, you can pay up to £2,880 a year into a pension and you’ll receive the basic-rate tax relief, taking your pension contribution up to £3,600.

It’s worth noting this rule applies to children, too. So, if you could afford to, you could start a pension for your children or grandchildren and they will enjoy tax relief too, just like their parents.

This is a very tax-efficient way to save for children and a lengthy investment horizon will give them a huge opportunity for their money to grow. However, it’s no good for helping to pay university fees or taking that first step on the property ladder, as they won’t be able to access it until they are much older.

What happens to tax relief once I access my pension?

You can keep saving into your pension even after you have withdrawn money, but the amount you can contribute and still claim tax relief on drops significantly.

In most cases, once you start taking money out of a defined contribution pension you trigger the Money Purchase Annual Allowance (MPAA), which replaces the annual allowance. This sees the amount of money you can pay into your pension each year fall from a maximum of £40,000 to just £4,000. That means you will only be able to pay in up to £4,000 a year into your pension and receive tax relief.

However, one important exception is where you are cashing in pensions worth £10,000 or less. These rules were introduced in 2015 to prevent people aged 55 or over taking money out of their pension and reinvesting it to claim further tax relief.

Is there a limit on how big my pension can be?

As well as putting a limit on how much you can pay into your pension each year, the government put a cap on how big your pension can become. This is known as the lifetime allowance.

The lifetime allowance is £1,073,100 for the 2020/21 tax year. If your pension is valued at more than this, you’ll pay a tax charge of 25% of the excess when you take an income from it, or 55% if you take a lump sum.

Will I pay a tax penalty when I make pension withdrawals?

While you enjoy tax relief when you pay money into your pension, when you take it out it will count towards your income for the year and become subject to income tax.

Once you turn 55 (rising to 57 in 2028) you can take 25% of your fund tax-free; you may see this referred to as a Pension Commencement Lump Sum. If you don’t want to take it all at once you can take it in smaller payments. In these cases, the first 25% will be paid tax-free and the remaining 75% will be taxed at your rate of income tax.

If you access your pension before you turn 55 and don’t meet the strict early access rules – say, you have a serious health condition or a terminal illness – you will pay a 55% tax penalty on anything you withdraw. This is why it is important you get professional pension advice before accessing your pension and are careful about pension transfers.

You can find out more in our complete guide to tax and pension withdrawals.

Source: Getty Images

About the author:

Ruth is a freelance journalist with 15 years of experience writing for national newspapers, magazines and websites. Specialising in savings, investments, pensions and property. Read more

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