10 essential things to know about pension tax relief

If investment compounding is the eighth wonder of the world, then pension tax relief should be the ninth. It’s an amazing way to boost your investment returns and beat inflation and rising taxes.

Here are 10 things to know about pension tax relief, how it works and how it helps you build wealth and keep more of your money.

1) How does it work?

Pension tax relief works differently depending on the type of pension scheme. Let’s start with a workplace scheme.

Normally, if you’re a basic-rate taxpayer, you’ll only get £80 in your pay cheque for every £100 you earn, because the taxman takes 20% tax from your pay.

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However, with a workplace pension scheme, your pension contributions are added by your employer through PAYE, without any tax being taken. This immediately reduces your tax bill and the tax you have saved is known as “tax relief”. If you’re a basic-rate taxpayer then for every £80 you give up, £20 tax relief will be added, meaning you can pay £100 into your pension with a cost to you of £80.

Higher-rate taxpayers save even more tax by paying into their pension. That’s because they pay 40% tax, so it will only cost them £60 to pay £100 into their pension.

If you pay into a private pension, then you pay in with money that’s already been taxed. Your pension scheme will receive a top up from the taxman automatically. This top up means an £80 contribution will be topped up by £20. The top up is the same whether you’re a basic or higher-rate taxpayer. Higher-rate taxpayers can claim an extra 20% back through their tax return: see point 5 below.

2) Immediately double your returns

If you pay into a workplace scheme, you can immediately double your investment. That’s because your employer will top up your pension, as well as pension tax relief being added.

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For a basic-rate taxpayer, it costs £80 to add £160 into your pension (£80 net contribution plus £20 tax relief, plus £60 employer contribution): immediately doubling your investment, assuming employee contributions of 5% and employer contributions of 3%.

For higher-rate taxpayers it costs only £60 to add £160 to your workplace pension: nearly tripling your original investment.

3) 40% tax relief is really 67%

We often think of tax relief as being 40% or 20%, but it’s actually higher. That’s because 40% is based on your pay before tax, whereas the cost to you of paying into your pension is lower: the after-tax amount.

For example, it only costs £60 for a higher-rate taxpayer to pay £100 into their pension scheme: it costs them £60 and they receive a £40 top up in tax relief. That means the effective return is actually 67% rather than 40% (£40 tax relief is 67% of the £60 net contribution).

4) Save as much as 60% tax

Although the higher rate of income tax is 40%, the weird tax system means many people pay more than this.

If you earn between £50,000 and £60,000 and have children under 18, you’ll lose child benefit, as well as paying 40% income tax. If you have two kids and earn £60,000, then you’ll potentially lose £1,885 as well as paying income tax of 40%, meaning your effective tax rate is 59% between £50,000 to £60,000. This is known as a marginal rate.

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If you earn between £100,000 and £125,000 you have a marginal rate of 60%. That’s because people earning more than £100,000 start to lose their personal allowance: the amount you can earn before paying tax. Losing the personal allowance as well as paying 40% income tax means that for every £1,000 you earn over £100,000, you’ll only get to keep £400.

Paying into your pension could help you avoid these sky-high marginal rates. For example, if you earn £60,000, and are entitled to child benefit for two children, you could pay £10,000 into your workplace pension (which would only cost you £6,000) after tax. This would reduce your net pay (pay after tax) to £50,000 and allow you to keep £1,885 child benefit. It would cost you only £4,115 in total (£6,000 minus £1,885) to pay £10,000 into your pension.

5) Remember to claim your tax rebate

If you’re a higher-rate taxpayer and you pay into a private pension, then you won’t automatically get 40% tax relief on your pension payments.

The government automatically adds 20% tax relief to your pension pot, but you’ll have to claim the rest through your tax return or by writing a letter to the taxman asking for rebate.

For example, if you earn £60,000 and pay £600 into a private pension during the tax year, you’ll get an extra £200 paid into your pension directly by HMRC, but you’ll also be owed an extra £200 tax rebate at the end of the tax year. You can claim this tax rebate through your tax return or, if you don’t do a tax return, you’ll need to write to HMRC setting out your private pension payments to receive your rebate.

The tax rebate will normally be received as a cheque rather than being added to your pension pot.

6) Tax relief even as a non-taxpayer

Even non-taxpayers and children can get tax relief on pension payments. They will get £20 added to their pension pot for every £80 they contribute.

Non-taxpayers can pay a maximum of £2,880 into their pension. Tax relief is added to their contribution, meaning that a maximum total of £3,600 can be paid into their pension each year.

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7) Tax relief even once you’re retired

Even once you’re retired, you can still get tax relief on your pension contributions up to the age of 75.

If you’ve already started withdrawing an income from your pension pot, you may be restricted to contributing £4,000 per year to your pension (including tax relief) under the money purchase allowance rules.

If you’re receiving a defined benefit pension, then you’re still allowed to contribute up £40,000 per year into a private pension.

8) Part of the state pension system

Not many people realise that pension tax relief is actually a key part of the state pension system in the UK. Many other European countries have a much more generous state pension system where the income you receive is linked to the level of contributions over your working life. In these countries, private pensions are less well used than in the UK.

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However, in the UK, we have a flat-rate basic state pension to provide a safety net. This is topped up by a well-used private pension system, that is supplemented by government tax relief. In reality, this means that tax relief is an integrated and important part of the state pension system.

9) Also save National Insurance

You can also save National Insurance by paying into your workplace pension. This is possible if you use something known as “salary sacrifice”. Using salary sacrifice means that you agree with your employer to reduce your pay and make pension contributions directly into your pension scheme. Because your pay reduces, you will also pay less national insurance.

You need to speak to your employer as not all employers often this option.

10) Use it or lose it

Pension tax relief can be backdated up to three years, but there are complicated rules to do so. You'll need to have been a member of a pension scheme in each tax year from which you carry forward; used your full annual allowance in the current tax year; contributed less than £40,000 in one or more of the last three tax years (including personal and employer contributions) and earned at least the amount you are contributing in that tax year if you are making personal contributions.

Like many tax rules, understanding the complex pension tax relief rules is the first step in helping us pay less tax and keep more of our hard-earned wealth.