Your pension fund – are you getting the most income tax benefit?

Published by Nigel Moon on 10 August 2021

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This article doesn’t go into the need to provide for your retirement – other than to say, if you haven’t got a pension plan, why not?  You may be surprised about what income tax and potentially Inheritance Tax benefits there are, in addition to helping to save for the future.

One of the principal advantages of a registered pension scheme is the income tax relief available when you make contributions to it, or your employer does.  In the case of employer contributions, payments are made in addition to your cash salary but not taxed on you, so relief is given that way.  These contributions may be what the employer pays as “its share” – or “your share” where you have a salary sacrifice arrangement with your employer under which you accept a cut in cash pay and the employer pays that reduction into your pension fund.

However, it is surprising how many people aren’t getting the full tax relief on the contributions they pay personally, so here are a few tips to try to help you make sure you aren’t missing out.

Employees

Confusingly, there are several ways in which contributions can be paid and where they pass through payroll it is not always obvious how or if tax relief is being given – and sometimes contributions are not correctly being dealt with, anyway.

If you aren’t clear if correct relief is being given, please speak with us and we can let you know what we need to see to be able to help you.

Salary sacrifice

Confusion can arise from the way that employers show salary sacrifice on payslips.  Typically, the pay figure excludes the amount sacrificed so that full tax relief is received under PAYE because the taxable pay shown is less than it would have been if salary sacrifice did not apply.  The payslips might show the contributions paid only as a note – or perhaps not at all.  Sometimes, the payslips might show the gross pay and then make a deduction for the amount sacrificed.

Contributions paid gross to the employer’s pension scheme

For some schemes, typically (but not only) “defined benefits schemes”, the contributions are paid “gross” (i.e. with no basic rate tax relief at source) and the payslips show the full pay with a deduction for the contribution paid by the employee to arrive at the “taxable pay”.  In this case, full tax relief is received under PAYE.

Contributions paid net of basic rate tax relief to the employer’s pension scheme

Here, the employee pays his contribution after deducting basic rate income tax relief.  For example, if he wants to get £100pm into the scheme he only pays £80 by way of contribution (£100 less 20% tax relief i.e. £20) and in that way receives basic rate tax relief at source.  The pension scheme then claims the £20 back from HMRC and in that way receives the full £100.

Since the net contribution is deducted from post-tax (i.e. net) pay no further tax relief is given under PAYE at this point.  This means that employees who are basic rate taxpayers receive their full tax relief so no further action is required.

However, if you are a higher rate taxpayer (for example, paying income tax at 40%) then you are due further tax relief, another 20% in this case.  If you file a tax return, then you should claim the extra relief in the return.  In any case – and especially important if you do not need to file a return – you can ask HMRC to incorporate an adjustment in your tax code (which shows the amount of salary you can receive before paying tax) which will give the extra relief under PAYE.

Contributions paid net of basic rate tax relief to your own pension scheme

In this case, contributions are paid direct from your bank account and so will not appear in your payslips.  This means that if you are a basic rate taxpayer, then you have received your full tax relief so no further action is required.

However, as above, if you are a higher rate taxpayer (so for example paying income tax at 40%) then you are due further tax relief, another 20% in this case.  If you file a tax return, then you should claim the extra relief in the return.  In any case – and especially important if you do not need to file a return – you can ask HMRC to incorporate an adjustment in your tax code (which shows the amount of salary you can receive before paying tax) which will give the extra relief under PAYE.

Self-employed

Generally speaking, this is the simplest situation as in virtually all cases contributions are paid net of basic rate tax relief.  This means that if you are not a higher rate taxpayer, then you have received your full tax relief at source.

However, as a self-employed person you would likely be preparing a tax return and so the pension contributions should be included in it.  This is especially important if you are a higher rate taxpayer as this is the only mechanism for claiming the extra tax relief.

What if my income is less than my personal allowance so I don’t pay tax?

The good news is that if you pay contributions next of basic rate tax relief, you get to keep that relief.

However, there can be some situations where contributions are paid gross – in which case you won’t receive any tax relief at all which means that the payments are costing more than they need to.  This is a problem that particularly arose in respect of “auto enrolment” affecting lower paid employees.  In most cases, contributions are paid net so there isn’t a problem.  In some cases, though, contributions were paid gross so affected employees were disadvantaged – so it may be worth checking your position.  A common provider used is NEST which operates a tax relief at source scheme, so there aren’t problems here.

What if I have no earnings?

Usually, to pay pension contributions you need earnings (from employment or self-employment) at least equal to your pension contributions (the gross equivalent where paid net of basic rate tax relief).

However, even if you have no income whatsoever, you can pay up to £2,880 net each year – this is equivalent to £3,600 pa less basic rate tax relief.  Even minor children can have schemes set up for them – which can be a useful and tax efficient way of grandparents providing for their grandchildren’s futures.

Is there a limit on how much tax relief I can claim each year?

Generally speaking, there is a limit of £40,000 that can be “paid” in terms of pension contributions and attract income tax relief.  For “defined contribution” schemes, this is the gross equivalent of employer’s and employee’s contributions and self-employed contributions.  For “defined benefits” schemes, this is a value calculated by a formula so the amount will have to be advised by the scheme administrators.

However, this limit is reduced where total income (after deducting certain payments) exceeds a set amount each year – be aware this takes into account total income and not just earnings.  Actually, there are two limits that are looked at called “threshold income” and “adjusted income” which are calculated in different ways.  Since 6 April 2020 these limits are £200,000 and £240,000 respectively – £110,000 and £150,000 before then.

Where income exceeds these limits, then the “annual allowance” of £40,000 is reduced by £1 for every £2 that “adjusted income” exceeds £240,000 (previously £150,000) subject to a minimum of £4,000 (previously £10,000).  However, it is possible to make use of “unused relief” from the three previous years to increase the amount that can be paid in the current year.

Where contribution values exceed the allowable amount, then tax relief is clawed back on the excess by way of a “pensions savings tax charge”.

If you have any concerns about your tax position, please get in touch with us.

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