Pension Contributions and Tax Relief – Pension Contributions and Tax Relief Factsheet
Contributing to a pension scheme allows you to make plans for retirement and ensure your income meets your future needs, it can also provide a valuable source of tax relief. This factsheet looks at the types of schemes, tax relief and allowances to consider.
Types of Pension Schemes
Broadly speaking there are two types of pension schemes – workplace pension schemes and personal pension schemes.
A workplace pension could be either a defined benefit scheme or a money purchase scheme. Defined benefit schemes are not very common nowadays but those individuals who are part of such a scheme will receive an income when they retire based on their earnings. A money purchase scheme, on the other hand, provides an income based on the amount contributed and invested in the plan in addition to the performance of the fund as a whole.
A personal pension scheme is a privately funded pension. It is a type of money purchase scheme and can be funded by an individual and/or their employer if they wish to do so.
Tax Relief on Money Purchase Schemes
Members of money purchase schemes can obtain tax relief on contributions into the scheme and benefit from tax free growth of the fund. Employers contributing to a money purchase scheme can also generally obtain a deduction from their taxable profits.
Since 2006, a lifetime limit exists which sets a maximum amount from which an individual can obtain tax relief. Annual limits also exist which limit the level of contributions that can be made into the fund each year.
Tax relief on contributions is given at an individuals marginal rate. The amount on which relief can be obtained is limited to the higher of £3,600 gross or 100% of their relevant UK earnings. Relevant earnings broadly includes employment income and income from a trade or profession. It does not generally include rental income but will include income from a furnished holiday letting business.
How does the Relief Work?
There are three ways for a member to claim tax relief on their personal contributions – via net pay, relief at source, HMRC self-assessment.
The Net Pay method allows contributions to be deducted by an individual’s employer from their salary before tax is calculated and paid. Tax relief is received immediately and directly by the employee.
If the contribution are made by an individual personally, it will usually be treated as being paid net of basic rate income tax. The pension provider can claim back this basic rate tax at 20% from HMRC, increasing the individuals pension pot.
For individuals who are higher or additional rate taxpayer, he or she can claim additional relief through their self-assessment tax return. The relief works by extending an individuals basic rate band by the gross contribution thus allowing them to obtain additional tax relief.
Sarah makes a net contribution of £8,000 into her personal pensions. Her provider claims £2,000 so a total gross contribution of £10,000 is paid into her pension pot.
She includes the contribution on her tax return which extends her basic rate band by £10,000, allowing her to claim an additional £2,000 of tax relief, making her net contribution £6,000.
The Annual Allowance
Tax relief is restricted for any contributions in excess of the annual allowance.
Current Annual Allowance
The current annual allowance is £40,000. Contributions above this could be charged to tax as an individual’s top slice of income.
From the 2016-17 tax year, the annual allowance is tapered for those with ‘adjusted annual incomes’ over £150,000. Broadly speaking, an individual’s adjusted income is their net income plus any pension contributions made by an employer. For every £2 of adjusted income, an individual’s annual allowance is reduced by £1 to a minimum of £10,000.
Tax Charge on Excess Contributions
Where contributions are made in excess of the available annual allowance, a tax charge is levied on the excess at an individuals marginal rate.
Amy works full time at a legal firm. She has taxable income of£110,000 in the current tax year and made contributions into her personal pension plan of £45,000. She has no unused allowances brought forward from previous years. Net contributions of £45,000 equate to gross contributions of£56,250. After deducting the annual allowance of £40,000 we see she has made excess contributions of £16,250 resulting in a charge of £16,250 x 40% = £6,500.
Unused annual allowances can be carried forward and used for a maximum of three years. The annual allowance for the current tax year is used before any unused allowance brought forward and the earliest year unused allowance is then used before a later year.
The Money Purchase Annual Allowance
There are additional rules around the level of contributions that can be made if an individual starts to take money from their defined contribution scheme. The rules are complicated but broadly speaking, if an individual starts to take money form their pension a lower allowance of £4,000 per annum can be triggered.
The lower allowance shouldn’t usually be triggered if an individual takes a tax-free cash lump sum and buys a lifetime annuity that provides a guaranteed income or takes the tax-free cash lump sum and puts their pension pot into flex-access drawdown but doesn’t take any income. It also shouldn’t apply to small pension pots valued at less than£10,000.
If the MPAA applies, any unused allowances can’t be carried over to another tax year.
The Lifetime Allowance
The lifetime allowances sets a maximum value of pay-outs from your pension scheme that can be made without triggering a tax charge.
The lifetime allowance for the 2018-19 tax year is £1,030,000. It encompasses the value of all the pensions an individual holds including defined benefit schemes (although the state pension is excluded).
If an individual exceeds the lifetime allowance, they will pay tax on the excess. The tax charge applied depends on how the funds are received.
Lump Sums: For lump sums, any amount taken in excess of the lifetime allowance is taxed at 55%.
Income: Any amount taken in excess of the lifetime allowance as regular income is taxed at a rate of 25%. This is in addition to any tax payable on the income at marginal rates.
There are schemes available to protect your lifetime allowance.
If your pension savings were greater than £1m on 5th April 2016 then there two schemes you may be able to apply for, fixing your lifetime allowance at a maximum of £1.25m.
This factsheet is based on law and HMRC practice at July 2018.