How pension tax relief works

Tax is rarely a relief so the term ‘tax relief’ can often confuse, especially when we’re told it’s one of the best things about pensions.

Here, we explain how pension tax relief works and why, provided you stick within your pension allowances, it can give your retirement savings a valuable boost.

What is pension tax relief?

Tax relief essentially means that some of the money that you would have paid in tax to the government goes into your pension instead. What this means in practice is that when you or your employer pays into your pension, the government will also chip in.

Most UK taxpayers automatically get tax relief on any pension contributions at the basic rate of tax which is 20%. So, if you wanted to add £100 to your pension, you’d only need to pay in £80, as the government would add the £20 it took in income tax.

If you’re a higher rate taxpayer who pays income tax at a rate of 40%, you can claim even more tax relief back, so paying £100 into your pension will cost you just £60. You’ll usually get 20% of this back automatically and then will have to claim the remaining 20% through your tax return or by calling HMRC.

The consumer association Which? has a useful pension tax relief calculator which can give you an idea of how much tax relief you’ll get on your contributions.

Some employers have what’s known as a ‘net pay’ arrangement so that your pension contributions are taken from your salary before income tax is paid on them, and the pension scheme claims back tax relief at your highest rate of income tax, which means you may not have to fill in a tax return. Check with your scheme provider if you’re not sure whether they do this.

Can non-taxpayers claim tax relief on pension contributions?

Yes, if you’re not earning enough to pay income tax, you can still get basic rate tax relief on pension contributions up to £2,880 each year. So if for example, you’re in a relationship and taking a career break, your partner might decide to make pension contributions on your behalf until you start work again.

If the maximum £2,880 is paid into your pension over the year, this means that once tax relief is added, you’ll end up with £3,600 of retirement savings.

Stay within tax relief limits

You’re only entitled to tax relief on a certain amount of pension contributions each tax year, known as your Annual Allowance.

This allowance enables you to get tax relief on pension contributions of up to 100% of your earnings, or £40,000 a year, whichever is lower, across all the pensions you have. If you’re earning £60,000 a year for example, that means you’d be able to pay up to £40,000 of this into your pension.

The £40,000 limit covers any contributions you or your employer make and includes tax relief.

You can carry forward any unused Annual Allowances from the previous three years, as long as you were a member of a pension scheme during those years.

If you’re on a very high income, your Annual Allowance reduces. If your income added to any pension contributions you or your employer make (known as your ‘adjusted income’) is more than £150,000, then for every £2 it goes over this limit, your Annual Allowance goes down by £1. The maximum amount it can reduce is £30,000, so if you have an annual income of £210,000 or more, your Annual Allowance will be £10,000.

The Chancellor announced in the Budget that these thresholds will change from the start of the new tax year on April 6, 2020. The Annual Allowance will only start to reduce for those with earnings over £240,000 from this date, but the taper will gradually shrink the minimum Allowance to just £4,000, down from £10,000.

There’s also a Lifetime Allowance, which is the maximum you can save into your pensions without having to pay any extra tax charges when you take money out of them.

The Lifetime Allowance is currently £1.055m but will rise to £1.073m in the 2020/21 tax year.

You can find out more about how the Annual and Lifetime Allowances work in our article Understanding your pension allowances.

What happens if I’ve already started taking benefits from my pension?

If you’ve started taking an income from your pension, but still want to keep paying into it, the good news is that you are still able to benefit from tax relief on future contributions. The amount you can pay in each year, your Annual Allowance, however falls to £4,000 and becomes known as the Money Purchase Annual Allowance (MPAA).

Accessing your pension

Bear in mind that you won’t be able to touch the money in your pension, including any tax relief on your contributions, until you reach the age of 55, rising to 57 by 2028.

It’s also worth remembering that pension tax rates and benefits can change and are dependent on your personal circumstances so there are no guarantees that current rules will continue to apply in future. If you’re not sure about investing or how pensions work, it can be a good idea to seek professional independent financial advice.

You can find a local financial advisor on VouchedFor or Unbiased.co.uk, or for more information, check out our guides on How to find the right financial advisor for you or How to get advice on your pension.

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