How Does Pension Savings Tax Relief Work?

Everyone from the age of 0 to 75 can make savings into a pension plan with the benefit of tax relief. Contributions paid in by employers are not taxable and personal contributions reduce the taxable income of the pension saver.

Tax relief is given at the taxpayer’s highest marginal income tax rate, but non taxpayers can also benefit from a 20% uplift in their savings, so that £8 saved becomes £10 invested.

Money invested in pension schemes also grows tax free and does not usually form part of the taxable estate of those who die leaving pensions funds invested. Up to 25% of the pension fund can be drawn as a tax -free lump sum. Any amount drawn over this is subject to income tax, at the rate of income tax applicable to the taxpayer when they draw the income.

Because pensions receive favourable tax treatment there are restrictions on how much can be saved with these tax benefits. The Annual Allowance restricts the amount that can be paid in each year with tax relief. The Lifetime Allowance sets an overall cap on the pensions which someone can build up over their lifetime. The Lifetime Allowance is currently £1,055,000 it increases each April by the Consumer Price Index.

The annual allowance of each taxpayer depends on their earned income or profits and whether the pension saving is paid by them or their employer. Any relief not used in the tax year can be carried forward for up to 3 years and relief claimed in the year it is paid. The table below sets out the limits on relief for different circumstances.

Saver Annual Allowance Tax relief Rate
Non earner £3,600 no carry forward relief if no earned income or profit At highest rate of income tax 20%/40%/45%
Employer £40,000 Non- taxable benefit
Employee (income below £110,000) Lower of 100% of earned income or £40,000, including employer payments  At highest rate of income tax 20%/40%
Self-employed income below £150,000 Lower of 100% of profits or £40,000 At highest rate of income tax 20%/40%
Employee with income above £110,000 plus employer payments, or £150,000 income Tapered allowance 10,000 to 39,999, including any employer payment. At highest rate of income tax 40%/45%
Self- employed with income above £150,000 Tapered allowance £10,000 to £39,999. At highest rate of income tax 45%
After withdrawal of £1 more than the tax-free cash on a flexible basis Lower of 100% of earned income or profits or 4,000 into pension pot and 36,000 into defined benefit pension. No carry forward from earlier years allowed. At highest rate of income tax 20%/40%/45%

What counts towards the annual allowance?
For money saved in a pension pot and reliant on investment returns, the total of payments made in the plan in that tax year are tested against the annual allowance.  For defined benefit pensions, the increase in the pension earned over the year is adjusted for inflation and multiplied by 16.

Extra benefits from making pension saving
Some taxpayers can achieve additional tax savings as the pension savings they personally make reduces their taxable income for other purposes. 
Adults living with children under 16, (age 20, if still in education), receive child benefit, a tax-free benefit unless one of them has income of £50,099 or more. Making pension contributions and charitable gifts can restore eligibility for this as the savings/ gifts made reduce the income assessed.

Once  taxable income is over £100,000 the tax -free income allowance is reduced. For every £2 of income over, it reduces by £1. Making pension savings or gift aid donations reduces taxable income, so may restore some tax -free allowance. This gives an effective rate of relief of 60%, making retirement saving and charitable giving more affordable.

Third party payments into pensions can be made within the allowances outlined above. These will qualify for tax relief at the pension saver’s highest income tax rate. They will usually count as exempt or potentially exempt gifts from the donor for inheritance tax purposes.

How is relief given?
Non taxpayers and basic rate taxpayers will get 20% relief automatically if they save into a scheme which operates relief at source (most stakeholder and personal pensions, but not all Self Invested Personal Pensions or workplace schemes).

Higher rate and top rate taxpayers and those seeking to reduce their taxable income for other purposes, who make personal savings will get basic rate relief at source but need to claim the extra relief via self-assessment. If payments are regular HMRC can adjust the tax code in subsequent years but changes in contributions must be notified to HMRC.

Workplace pensions which operate on a net pay or salary sacrifice basis will automatically grant all tax relief for taxpayers. Non taxpaying employees do not get relief unless their employer offers a relief at source scheme, but the Government is looking at ways to rectify this.


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