Pensions provide a number of tax benefits that, when combined, can give a considerable boost to your final retirement fund. In this article, we explore these benefits and look at how you can make the most of your pension pot.
Pension tax relief – what is it?
One of the best reasons to save for a pension is the tax relief that you earn. Every time you contribute to your pension, a portion of the money that you would have paid in tax goes towards your pension instead. This means that
- You pay less tax to the government
- You’re giving a boost to your savings
How much tax relief you get depends on the rate of UK income tax you pay.
How does pension tax relief work?
There are two ways for you to earn tax relief on your pension payments
- Net pay method
- Tax relief at source method
Which you use can depend on your work circumstances. If you contribute to a workplace pension, then your employer decides which method to use. If paying into a personal pension, you’ll use the tax relief at source method.
Net pay method of claiming tax relief
Using this approach, your pension contributions come out of your pre-tax income. This means you’ll pay less tax because your earnings will be less. In practice, it works like this –
- Your employer deducts your pension contribution from your pay before tax is deducted.
- You then pay tax on your UK earnings after you’ve paid your pension contribution. This means a lower tax bill and more take-home pay.
By taking this approach, whatever rate of tax you pay, you get full tax relief without having to claim it. The one drawback? If you don’t pay tax (for example, you earn below the current tax threshold of £12,570 for the tax year 21/22), then you get no tax relief.
Tax relief at source method of claiming tax relief
Following this path, your pension contributions earn a boost from the government.
This is how the relief at source approach works
- Your employer deducts tax from your taxable UK earnings in the usual way.
- They then deduct your pension contribution from your post-tax pay and pass this to your pension provider. If you’re self-employed, you simply make a contribution from your taxable UK earnings to the pension provider.
- Your pension provider then claims 20% in tax relief directly from the government, which they add to your pension fund. (In Scotland, things work slightly differently – if you pay tax at the Scottish starter rate of 19%, you still earn tax relief on your pension contributions at 20%.)
If you don’t pay tax, then this method is better because you still get tax relief.
You have the added benefit that if you pay tax above the basic rate, you may be able to claim more back through your tax return. But you must do this through your annual tax return or directly from HMRC.
What if I don’t pay tax and my employer uses the Tax Relief at Source approach?
In this instance, there’s little you can do. Your employer can’t pick and choose which system he uses from one employee to the next. He has to operate the same process for all employees.
You do, however, still have the option of asking your employer if they will top up your scheme by the tax relief amount or pay into another pension scheme that will give you tax relief. However, they aren’t obliged to do this for you.
Advice on tax relief on pensions
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Pensions provide a number of tax benefits that, when combined, can give a considerable boost to your final retirement fund. In this article, we explore these benefits and look at how you can make the most of your pension pot. Pension tax relief – what is it? One of the best reasons to save for […]