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Do you understand how tax relief on your pension contributions works?
With the introduction of ‘auto enrolment’, more and more people are saving towards a pension. Most – but not all – people get a government top up to their pension savings in the form of tax relief on their contributions. The way it is given differs depending on what kind of pension scheme you are in or whether you are in a salary sacrifice arrangement. And the position is even more confusing if you are a Scottish taxpayer or are receiving tax credits or other benefits. Here we explain how it all works.
We do this under the following headings:
What is pension tax relief?
How pension tax relief works
Net pay arrangements
Relief at source
Pension tax relief for low-earners
What is salary sacrifice?
Important note about salary sacrifice for low earners in relief at source schemes
Interactions with tax credits and universal credit
When you save into a pension, the government usually gives you a top up as a way of encouraging you to save for your future. This top-up comes in the form of tax relief.
Tax relief is available on your pension contributions at the highest rate of income tax that you pay. So, for non-Scottish taxpayers, this means:
- Non-taxpayers (i.e. people who earn under the personal allowance) get no pension tax relief – unless they are in a ‘relief at source’ scheme – see below for more information
- Basic-rate taxpayers get 20% pension tax relief
- Higher-rate taxpayers get 40% pension tax relief
- Additional-rate taxpayers get 45% pension tax relief
In Scotland, there are different income tax rates so pension tax relief is applied in a slightly different way – see our section on Scottish taxpayers for more information.
The way pension tax relief works differs depending on what kind of pension scheme you are in:
- If you are in a ‘net pay’ arrangement the pension contribution is deducted before tax is calculated on your pay (meaning you receive tax relief there and then).
- If you are in a ‘relief at source’ arrangement – the pension contribution is deducted after tax is calculated and HM Revenue & Customs (HMRC) later send the value of the tax relief to the pension scheme.
‘Net pay’ arrangements are used by many traditional occupational (‘works’) pensions and also some workplace pensions set up under the recent auto enrolment programme, and don’t require you to do anything to get your tax relief.
Your pension contributions are deducted from your salary by your employer before income tax is calculated on it, so you get relief on the amount immediately at your highest rate of tax.
So, if you earn £300 a week, and pay 3% (£9) in pension contributions, you will only pay tax on wages of £291. As you don’t pay tax on the £9 of your earnings that you put in as your pension contribution, you are therefore saving tax of £1.80 (£9 x 20%), meaning your £9 contribution is only really costing you £7.20.
You do not need to put details of pension contributions made in this way on your self assessment tax return (if you complete one) or tell HMRC about the contributions in any other way at all. This is because exactly the correct amount of tax relief will have been given on the contribution via the payroll and there is nothing else to do.
‘Relief at source’ arrangements are used by personal and stakeholder pensions (that is, pensions set up with an insurance company) and some auto enrolment workplace pensions.
If, like most taxpayers in the UK, you are a 20% taxpayer (a basic rate taxpayer), you will make your contribution out of income that has already had 20% tax deducted.
Therefore if you are paying into a pension through your employer, your employer will only take 80% of your total pension contribution from your salary and send it to your pension scheme. Your pension scheme then sends a request to HMRC, who pay an additional 20% tax relief into your pension.
So, again, if you earn £300 a week, and pay 3% in a pension contribution, you will only actually have £7.20 deducted from your pay, and the government will put £1.80 into the pension scheme by way of tax relief at a later date. This tops-up your £7.20 contribution to £9.
If you are a 20% taxpayer, there is no further adjustment that needs to be made. However, under this system, higher and additional-rate taxpayers must make a claim to receive the extra relief due to them.
If you are a higher or additional rate taxpayer and you normally complete a self-assessment tax return, tell HMRC about your pension contributions – and claim any tax relief – by completing the appropriate section on your tax return. If you do not complete a tax return, you can give the details on form P810 Tax Review – this is not available online and is only available by contacting HMRC.
If you pay tax through PAYE, HMRC can give you any relief through your tax code – meaning any refund will be paid when your wages or pension is paid to you, generally by way of a lower tax deduction than you would otherwise have suffered. If not, you may have to obtain a refund directly from HMRC.
One point to note is that if you are a low-earner (i.e. if you earn below or only just above the personal allowance – £11,850 in 2018/19), you may wish to check which type of pension scheme you are in. If you are in a ‘relief at source’ arrangement, the pension provider claims 20p tax relief back from HMRC for every 80p of your contribution received – no matter what the level of your earnings.
If, however, you are in a ‘net pay arrangement’, you won’t get any tax relief. Many people think this is unfair and there are growing calls, including by LITRG, for the Government to change the rules.
Jo earns £950 per month. Jo puts in £15 of her pay into her pension scheme every month. The pension scheme operates under net pay arrangements, so her employer deducts the pension contribution before calculating tax. This means Jo’s earnings are taken to be £935 for tax purposes instead of £950. However, as Jo’s earnings fall below the usual monthly threshold for paying income tax (£987.50), this reduction in taxable income makes no difference and she gets no tax relief on the contributions paid.
If Jo was in a relief at source scheme, her taxable employment income would be £950 a month. She would still not pay any tax, but she would only have to put 80% of £15 (i.e. £12) of her pay into her pension pot – the rest is paid into it for her by the government. She is therefore £3 a month, or £36 a year, better off under a relief at source scheme.
Many employers offer to run their employees’ pension schemes in conjunction with a salary sacrifice arrangement. They do this because it saves both you and them National Insurance.
To explain: An employee’s pension contributions usually attract tax relief (provided they are a taxpayer), but they do not ordinarily attract National Insurance contributions (NIC) relief. However, if an employer makes a contribution to an employee’s pension scheme, then there are no tax or NICs to pay on the value of the contribution.
Under a salary sacrifice arrangement, you agree to give up part of your salary in return for your employer making a larger contribution to your pension pot. This can save you money because the National Insurance you would be due to pay is calculated on the smaller salary. The employer would pay any employer’s NICs on the smaller salary too. You may also benefit from more pension contributions from your employer, if they are willing to contribute some of the money they are saving on employer’s NICs.
A salary sacrifice arrangement involves altering your employment contract to give up a portion of your earnings. This may affect future calculations of pensions, redundancy pay, statutory maternity pay, paternity pay, shared parental pay etc. You should make sure you are clear on these employment law aspects before deciding to enter into a salary sacrifice arrangement so you fully understand how they may affect you in the future.
You should also be aware that a salary sacrifice arrangement is not allowed to reduce your cash pay below the relevant National Minimum Wage or National Living Wage rates. This rule is in place because of fears that people on lower incomes may sacrifice their salary to an amount below the Lower Earnings Limit, that is, the limit at which you start to accrue entitlements under the social security system. Your employer should be keeping an eye on this, but there is no harm you doing so too.
If you are paid slightly more than the minimum wage, it is important to watch out for any changes to the minimum wage rates. This is because a rise in the minimum wage rate could affect your ability to salary sacrifice.
As we have seen above, even if you are a low earner and don’t pay tax, you still get a 20% top up into your pension pot if you are in a relief at source scheme. However if your employer offers you a salary sacrifice arrangement alongside, you should be aware that while you will save National Insurance, you will lose the 20% top up into your pension pot, so could actually find yourself worse off
This is probably best explained by looking at an example:
Dave earns £11,500 per year (£221.15 per week). He is paid at just above the minimum wage. The personal allowance of £11,850 means he pays no tax, however employee NIC is due at 12% on his earnings over £162 per week. He is in a relief at source pension scheme. His contribution amount is £3.15 per week (which under normal procedures, translates as an actual deduction of £2.52 – i.e. 80% of £3.15).
With no salary sacrifice arrangement, his weekly payslip will look something like this:
Although Dave has only had £2.52 deducted from his salary, £3.15 will end up in his pension as 0.63p extra will be sent to the pension scheme by HMRC.
With a salary sacrifice arrangement, his weekly payslip will look something like this:
In this scenario, Dave has given up £3.15 of his salary, so that this employer can pay the amount over to the pension scheme as an employer contribution. His take home pay is therefore reduced by 26p (i.e. 8% of the pension contribution). By salary sacrificing he is saving 37p in National Insurance (i.e. £3.15 x 12%), but losing 63p on the pension contribution deduction (i.e. the difference between £3.15 and the £2.52 it would have been under normal procedures).
The different tax rates that apply for Scottish taxpayers, have the following effect on pensions tax relief:
For net pay schemes – tax relief will be given immediately at your marginal rate of tax – i.e. 0%, 19%, 20%, 21%, 41%, 46%.
For relief at source schemes – Non-taxpayers and basic rate taxpayers will continue to get tax relief at the basic rate of 20%. Scottish taxpayers who pay the Scottish starter rate of income tax at 19% will get tax relief at 20% on personal contributions. HMRC have confirmed that they will not recover the 1% difference.
Those paying 21%, 41% or 46% can claim extra relief in the same way as those in the rest of the UK.
An anomaly therefore exists for Scottish taxpayers whereby 19% taxpayers in relief at source arrangements get 20% tax relief, whereas 19% taxpayers in net pay arrangements only get 19% tax relief.
If you get a means-tested benefit like universal credit or tax credits, your pension contributions will reduce the amount of income that is taken into account in assessing your award. This could mean a higher award.
For example, universal credit’s ‘taper rate’ of 63p in the pound means that a £100 pension contribution over the course of a year could result in a £63 increase in your UC award depending on your level of award and circumstances.
You should check the position carefully for whatever benefit you are claiming as the steps you need to take to make sure the authorities know about your pension contribution amounts, might depend on whether you are in a net pay scheme or relief at source.
For example, tax credits are based on gross income – before tax and National Insurance are deducted. If you make contributions under a net pay arrangement then the taxable income figure on your P60 will already reflect your pension contributions. You won’t need to make any further adjustments for pension contributions.
But the gross income figure from your P60 will not reflect any relief at source pension contributions and you will therefore need to deduct your pension contribution amount from your income figure when you report it to HMRC. The amount to deduct is the amount of pension contribution grossed up by 100/80 – to reflect the 20% top up that will be claimed from HMRC by your pension scheme.
You can read more about this on our website for advisers, RevenueBenefits.
You can find some basic information about tax relief on GOV.UK.
You can find more information on pension tax relief and auto enrolment on our website.
To understand more about the benefits of saving into a pension see our news piece.
You can find out more about saving into a pension, including more on salary sacrifice, on the Pensions Advisory Service website.