November 2017: Tax relief for pension contributions
For many years, the government has incentivised taxpayers to build up their pension pots by providing tax relief for contributions. We frequently find that there is some confusion about the different ways in which tax relief for pension contributions is obtained and the limitations on that tax relief.
Types of pension contribution
The way in which relief is given depends on the type of contribution made; there are essentially three different types:
- Personal pension contributions (e.g. to a stakeholder or personal pension plan) – these can be arranged and paid directly by the taxpayer, or group personal pensions can be set up by employers to allow easy payment into schemes by deduction through payroll.
- Employee pension contributions – where an employer has set up an occupational pension scheme, payments can be made by deduction from salary.
- Employer (or company) pension contributions – these are paid by the taxpayer’s employer or personal company and can be to any type of pension scheme; these may be made in conjunction with a salary sacrifice arrangement.
As you might expect, the tax reliefs available under each type of contribution are broadly equivalent but work in very different ways.
For personal contributions, the government tops up contributions by basic rate tax of 20%; so by paying in (“net”) £800 you get a total (“gross”) pension contribution of £1,000 added to your pension pot. In addition, for those paying higher rate tax further relief is obtained through the tax return. This works by adding the gross contribution to the basic rate band, so in this example (for a higher rate taxpayer) £1,000 moves from being taxed at 40% to 20%, saving a further £200 of tax. This is why it is important to include all personal contributions on your tax return.
Gross personal contributions are also limited to the higher of £3,600 and the taxpayer’s earned income (i.e. salary or self-employment profit) for a tax year.
Employee contributions are deducted from gross salary before calculating the tax, so these automatically obtain relief at the taxpayer’s marginal rate.
Employer contributions are not taxable income, so these effectively obtain relief by virtue of never being taxed on an employee (although note that a tax charge will apply if the annual allowance is exceeded – see the limitations mentioned below). In general the employer will get a tax deduction for any contributions as an expense of their business. If a salary sacrifice arrangement is entered into, the employee varies their contract to give up a certain amount of salary (which would otherwise be subject to both tax and National Insurance) in return for a pension contribution which is subject to neither.
Note that where personal pension contributions are taken from salary, this will be an after tax (and NI) deduction, so very different in this sense from either an employee contribution or a salary sacrifice arrangement which give rise to deductions before the calculation of tax and, as mentioned above, it is therefore important for higher rate taxpayers to include such deductions on their tax returns in order to obtain that higher rate tax relief.
There are both annual and lifetime limits for tax relieved pension contributions, both of which have reduced significantly over recent years. The annual limit is currently £40,000 and the lifetime allowance for pension pots is £1million. However, there are many and increasingly complex rules surrounding both of these allowances and we advise our clients to contact us if you are hoping to add more than £10,000 to a pension scheme in a tax year or if you are concerned that your total pension pots are approaching the lifetime allowance.
Written by: Emily Orton, Lakin Rose Chartered Tax Adviser