In our weekly series, readers can email in with any questions about retirement and pension savings to be answered by our expert, Rachel Vahey, head of public policy at investment platform AJ Bell. There is nothing she does not know about pensions. If you have a question for her, email us at money@theipaper.com.
Question: I am a higher rate taxpayer – earning more than £50,000 – and have been for 40 years, but I don’t understand the concept of tax relief on pensions. how does it work?
Answer: Pensions are one of the most tax-efficient ways to save for retirement. Contributions aren’t taxed, investment growth is exempt from income and capital gains tax, and up to 25 per cent of withdrawals can be taken as a tax-free lump sum, with income tax applied to the rest.
How the tax relief on pension contributions works depends on the type of pension scheme you are paying into.
Some occupational pension schemes operate a system of tax relief called net pay. Under this, you pay contributions from your earnings before tax has been deducted. Pension contributions are exempt from income tax, and you automatically get the tax relief at the highest rate of income tax you pay.
For example, someone earning £80,000, and paying pension contributions of £10,000 are saving paying 40 per cent tax on that £10,000.
Other pension schemes, including most personal pensions, operate a tax system called relief at source. Under this version, you pay your contributions from earnings that have already been taxed, and you can get back the tax you’ve already paid on your contributions.
Here’s how it works: after you make your pension payment, your pension provider makes a claim for income tax relief. The government then adds tax relief at the basic rate and pays this straight into your pension pot. So if you pay in £8,000, the government tops it up with an extra £2,000 – making your pension contribution £10,000 in total.
If you pay tax at the higher or additional rate, you’re entitled to extra tax relief on your pension contributions. The pension contribution increases your basic rate tax band by the grossed-up amount and so reduces the taxable income subject to higher (40 per cent) or additional (45 per cent) rates.
HMRC will then owe you a refund for the difference between what you paid in higher or additional rate tax and the basic rate. You can claim this extra tax relief when you fill out your self-assessment tax return, or, if you’re a higher rate taxpayer, you can also make your claim online.
Let’s look at the £80,000 earner example again. If they put £8,000 into their pension, the government tops this up with £2,000 to their pension pot to bring in up to £10,000. Because they pay tax at the higher rate, they can also claim back another £2,000 through their tax return or online. This extra money can reduce their tax bill or be paid straight to them. So, in the end, adding £10,000 to their pension actually costs them just £6,000 out of their own pocket.
Even if you don’t pay any income tax, the government will still give you 20 per cent tax relief on your pension contributions. The most you can pay in as a non-earner is £2,880, and with the government’s 20 per cent top-up, your pension pot will receive £3,600 in total.
There are also limits on the amount you can pay into your pension and receive tax relief on. Broadly, your personal contributions are limited to 100 per cent of your earnings. There is another limit of £60,000 that includes your contributions, any employer’s contribution, and tax relief.
As you can see tax relief on pension contributions is a very valuable tax perk. It’s worthwhile for those who pay more than basic rate tax and contribute to a self-invested personal pension (or another relief at source pension scheme) to reclaim the additional tax relief they are owed. Otherwise, it’s free money going to waste.