What Is Pension Tax Relief and How Does Pension Tax Relief Work?
One of the best features of using a pension to save for retirement is tax relief. When you pay into your pension, some of the money that would have gone to the government as tax goes towards your pension instead. This can help reduce the amount of tax you pay and boost your savings for the future.
This tax relief is provided based on the rate of Income Tax that you pay. However, depending on your pension scheme, you might not receive tax relief if you don’t pay tax. Equally, additional tax relief might need to be claimed if it is not automatically applied by your scheme. Certain limits apply that can impact the amount of tax relief you’re entitled to, and exceeding these limits could result in a tax charge that effectively claws back excess tax relief.
How Does Pension Tax Relief Work?
There are two main ways to receive tax relief on your pension contributions: relief at source and net pay. The method used depends on whether you’re in a workplace pension or a personal pension.
Relief at Source
With the relief at source method, your contributions receive a boost from the government. If you pay tax above the basic rate, you may be able to claim additional relief through your tax return.
Here’s how it works:
- Tax is deducted from your taxable UK earnings as normal.
- Your pension contribution is taken from your after-tax pay and sent to your pension provider.
- Your pension provider claims 20% tax relief directly from the government and adds it to your pension pot. In Scotland, where the starter rate of tax is 19%, relief is still applied at 20%.
This method is beneficial for individuals who don’t pay any tax, as they can still receive tax relief. However, those paying higher tax rates will need to claim additional relief via their tax return or directly from HMRC.
Net Pay
Under the net pay method, pension contributions are made before tax is calculated, reducing your taxable income and, consequently, your tax bill.
Here’s how this method works:
- Your full pension contribution is deducted from your pre-tax pay.
- Tax is then calculated on your earnings after the pension contribution is deducted.
- You receive immediate tax relief as your tax bill is reduced.
While effective for taxpayers, this method does not provide tax relief for individuals who do not pay tax.
Tax Relief If You Don’t Pay Tax
If your earnings fall below the Personal Allowance (£12,570 for the 2024/25 tax year), your eligibility for tax relief depends on your pension scheme’s method:
- Net Pay Method: No tax relief is provided for non-taxpayers under this method. However, from the 2024/25 tax year, the government will introduce top-up payments for eligible contributors, with the first payments expected in the 2025/26 tax year.
- Relief at Source Method: Pension providers claim basic rate tax relief from the government and add it to your contributions, even if you don’t pay tax, up to certain limits.
Example of Tax Relief Methods
| Method | Income | Contribution | Taken From Pay | Tax Relief |
|---|---|---|---|---|
| Net Pay | £10,400/year | 3% (£6/week) | £6 | £0 |
| Relief at Source | £10,400/year | 3% (£6/week) | £4.80 | £1.20 |
While both methods add £6 to your pension, net pay reduces take-home pay more than relief at source.
Limits on Tax Relief
There are limits on pension contributions eligible for tax relief:
- Earnings Limit: Contributions must not exceed your relevant UK earnings. For instance, if you earn £20,000 but contribute £25,000, tax relief is only available on £20,000.
- Annual Allowance: Most individuals can contribute up to £60,000 annually. Contributions exceeding this limit may incur a tax charge.
Special rules apply for high earners and those taking flexible retirement income:
- Tapered Annual Allowance: Reduces the allowance for high earners to as low as £10,000.
- Money Purchase Annual Allowance (MPAA): Limits contributions to £10,000 for those accessing flexible income from their pension.
Unused allowances from the past three years can be carried forward, allowing for higher contributions with tax relief. Tax relief is available only on contributions made before age 75.
How to Check Your Tax Relief Method
You can confirm your scheme’s tax relief method by checking your scheme booklet, contacting your HR department, or speaking directly with your pension provider. Ask whether the scheme operates using:
- Net Pay Method: Full contribution deducted from pre-tax pay.
- Relief at Source Method: Lower contribution deducted after-tax and tax relief claimed by the provider.
Understanding pension tax relief is crucial for maximising your retirement savings. Whether you’re looking to find the best financial adviser near me or seeking an independent adviser for tailored advice, a professional can help you navigate tax relief rules and ensure your contributions align with your financial goals. With expertise in pension protection and financial planning, the right service can offer peace of mind and greater confidence in your retirement strategy.
Founded in 2017, Fintuity has fast become one of the only digital Independent Financial Advisers (IFA) in the United Kingdom. Fintuity offers a wide range of financial advisory services including pensions, protection, investments and mortgage advice. The key difference is that as an exclusively digital service, we can offer significant savings and a service that is direct to you and on demand. Information correct as at time of publishing on 22nd January 2025.
