Pensions tax relief – How it works

Pensions tax relief – How it works

For decades now pension tax relief has been the cornerstone of policy for successive governments to promote saving for retirement and to reduce dependence on the state pension. Alongside specific initiatives, such as employer auto-enrolment obligations, most workers will now have some kind of pension nest egg.

Here, we explore all the key aspects of pensions tax relief and how it may affect you. If you are looking for help or advice on pensions tax relief or any other pension tax issue please contact Chris Holmes or Helen Jones.

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The basic rules 

Contributing to a pension has always been a tax-efficient method to save towards retirement. If you are UK resident and under 75, you will be eligible for tax relief on contributions into your pension. In order to get full tax relief, the amount you can pay into your pension is restricted to the higher of:
  • £3,600 gross (£2,880 net)
  • The amount of your relevant UK earnings; but to a maximum of your annual allowance for the year (from 6 April 2023, usually £60,000 - but see below).

Most contributions to personal pension schemes are paid net of basic rate tax relief (via a relief at source scheme), so the only additional relief is through a claim on the self-assessment tax return for higher rate relief. This extra tax relief is given by extending the basic rate band by the gross amount of the pension contribution.

In contrast, employees making contribution into their employer’s occupational scheme will receive full relief at source as the contribution will be paid out of gross income before tax is calculated on the balance (via a net pay scheme). This applies equally to salary sacrifice arrangements.

Tax relief extends to the growth in the value of pension savings, as the pension fund itself will not pay tax on its investment returns.

Having effectively paid monies into the pension scheme and grown the fund tax free, it is then usually possible to extract 25% of the ‘pension pot’ (up to the lifetime allowance – see below) as a tax-free lump sum when you commence drawing down retirement benefits currently from the age of 55 (although there are plans to increase this age to 57 from 2028).

The remaining 75% of your pension pot will usually be taxed through PAYE as and when you receive it at your marginal rates of income tax, which will depend on your level of all other taxable income in that tax year.

There are many different types of pension arrangements. A personal pension plan can be set up through a pension provider, as opposed to an occupational pension which is set up by employers. Employers are now required by law to offer a workplace pension scheme and to automatically enrol eligible employees into it. 

Defined Contribution schemes (also known as money purchase arrangements) are occupational schemes where an employee (possibly with additional employer contributions) builds a pension fund and the employee eventually decides how to use the pension pot on their retirement. Any investment risks rest solely with the employee whose eventual benefits will depend on the growth of the fund.

Defined Benefit schemes (also known as final salary or earnings-based schemes) are occupational schemes where contributions are made to a general fund from which an employer promises to pay an amount of pension to an employee on their retirement. The amount of pension the employee receives is based upon how long they have worked for their employer and their level of earnings during their years of ‘pensionable service’ (normally the level in the final years prior to retiring or leaving the scheme). These schemes are becoming increasingly rare and many are closed to new joiners. Any investment risks rests solely with the employer as they must ensure that there are sufficient funds available in the pension fund to eventually pay the promised benefits.

Personal Pensions are schemes set up by an individual, often self-employed, for themselves. They are in practice a money purchase scheme and the investment risk rests with the individual member as with any Defined Contribution Scheme. Contributions are paid net of basic rate tax, with higher rate relief claimed through completion of tax returns.

Group Personal Pensions are occupational schemes that operate for the member on a similar basis as personal pensions. The employer acts as agent through its payroll by withholding contributions out of net pay. Higher rate relief for contributions are claimed either through a tax code adjustment or by completion of a tax return. The employer will often make additional contributions to the scheme.

Self-invested personal pensions (SIPPs) and small self-administered schemes (SASSs) – SIPPs and SSASs are types of personal pension scheme but they allow the member greater control over the investment of the funds.

Retirement Annuity Policy schemes (RAPs) - If you took out a personal pension before 1 July 1988, it will most likely have been a retirement annuity policy. Quite often these included insurance policies with any payments also treated as being pension payments.

Additional Voluntary Contributions (AVCs) might be made by employee into a defined contribution scheme. An employer might set up such a scheme to run alongside a defined benefit scheme to enable staff to make additional pension savings. With the closing of many defined benefit schemes AVCs are becoming less common.

If your level of threshold income (net income after pension contributions) is below £200,000 you can make gross contributions to your pension funds without an income tax charge up to the annual allowance limit, which for the tax year 2024/25 is £60,000.

If your adjusted income (net income plus personal contributions and employer pension input) exceeds £260,000, and your threshold income exceeds £200,000, your AA will be tapered at a rate of £1 for every £2 of adjusted income above £260,000. The maximum reduction to the AA is by £50,000, so anyone with adjusted income of £360,000 or more has their AA tapered to the £10,000 minimum. 

If the increase in the value of your pension rights or your contributions (including employer contributions) exceeds the AA, there is a tax charge on the excess amount. The tax rate of the ‘annual allowance charge’ is at your marginal rate and depends on your level of taxable income.

However, any unused AA can be carried forward for three years and utilised if the AA for a subsequent year is exceeded. You may therefore have unused AAs from any of the past three tax years which can be used in addition to your current year AA limit and therefore increase your maximum tax-relieved pension contributions of the year.

However, this restriction does not apply for withdrawals from defined benefit schemes or for withdrawals of the 25% tax-free lump sums.

Up to 5 April 2023, a lifetime allowance (LTA - £1,073,100 for 2022/23) applied to total pension savings (from all pension schemes). Where this limit was exceeded, tax may have been due on the excess when pension benefits were accessed, or in certain other circumstances known as ‘Benefits Crystallisation Events’.

After the LTA was introduced, individuals were able to protect the higher LTA limit by making a relevant ‘protection’ claim. However, protection was only available in certain circumstances and, dependent on the protection taken, could be lost if any additional pension contributions were made by the individual (or their employer) after the relevant date. 

From 6 April 2023, the LTA charge was abolished. The LTA limit will, however, continue to exist for the purpose of capping the 25% tax-free lump sum available when first accessing a pension. This means that for most people the maximum tax-free lump sum they could accrue will be £268,275. However, where a pension protection is held, the maximum lump sum is 25% of the protected amount.

Employers are required to automatically enrol eligible employees into a qualifying pension scheme and make contributions on an employees’ behalf. Usually, an employee’s pension contribution will be deducted from their net pay through an automatic enrolment scheme. From April 2023, an employer and employee must pay a minimum of 3% and 5% respectively under the automatic enrolment scheme, based on the employees’ qualifying earnings.

An employee can enter into a salary sacrifice agreement whereby they agree to a reduction in their gross pay in favour of an increased employer pension contribution. The tax position remains the same, but importantly the employee is receiving less remuneration for NIC purposes, and there is therefore an NIC saving for both the employee and employer.

It is important to remember that under a salary sacrifice arrangement, employees will not actually be making a pension contribution; they are sacrificing salary and personal contributions in favour of increased employer contributions.

Similar to Salary Sacrifice schemes, SMART pensions are a way to reduce employment costs for employers, while maintaining or enhancing employees’ pension benefits.

SMART pensions enable an employee to enter into a salary sacrifice agreement whereby they cease to make a contribution from their pay: instead, they agree to reduce their gross pay in favour of an increased employer pension contribution. The tax position remains the same, but importantly the employee is receiving less remuneration for NIC purposes, and there is therefore an NIC saving for both the employee and employer.

This idea has been around for a number of years; however, as part of the introduction of the Optional Remuneration legislation, it was confirmed that the use of salary exchange for pension savings would continue to benefit from tax and NIC relief.

The UK has a very generous tax system in place when it comes to passing on your pensions savings to your family members or any beneficiary of your choice on death. Currently, pensions savings can be passed on free of inheritance tax to any beneficiary in accordance with a deceased’s letter of wishes/nomination form.

The abolition of the LTA may lead to changes in widely-used pension withdrawal strategies, however, if a person makes a deliberate decision to not draw their pension so it can pass on death to their beneficiaries, the IHT exemption might be denied.

Income tax implications may apply for beneficiaries receiving rights to the pension fund in certain scenarios, although in some cases the beneficiary may be able to draw on the pension fund tax-free of both income and inheritance taxes depending on the age of the pension holder at the time of death.

You may have accrued benefits in an overseas pension scheme whilst working for an overseas employer. If you are UK-resident, there are income tax implications to consider if you wish to access benefits from your overseas scheme in the form of an annuity or lump sum payment. Overseas pension schemes are a complicated area of pension taxation and legislation.

Generally, UK income tax is payable on overseas pension income (including equivalent state pensions) of a UK tax resident individual, subject to treaty provisions and possibly remittance basis (for non-UK domiciliaries).

Lump sums from overseas pension are a particularly complex matter for which specialist advice is required. Lump sums can theoretically fall to be taxed under a number of different provisions depending on the facts. If you are able to satisfy yourself that the other provisions do not apply then the general provisions introduced with effect from April 2017 will most likely be relevant.

Under these provisions, providing there is sufficient relevant foreign service, a pension pot deriving from such foreign service may only be taxable to the extent that it has accrued or increased in value since 6 April 2017. Even this subsequent growth might be fully exempt or subject to the standard UK ‘25% tax free’ provisions depending on circumstances.

Should you die and your pension pot passes to another person, the IHT implications applying to overseas schemes depend on the characteristics of the scheme and on your UK domicile status. If you are a UK domiciled or deemed UK domiciled individual, your overseas pension funds may fall within your death estate.

Beneficially, offshore schemes that are registered or recognised in the UK are treated in the same way for UK IHT purposes as UK schemes, and will therefore benefit from the same IHT exemptions. For example, Qualifying Non-UK Pension Schemes (QNUPs) are offshore schemes that are also outside the scope of UK IHT.

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