Over the years since the tax system for pensions was ‘simplified’ in 2006 there have been changes almost every year. Here we explain the current tax benefits when it comes to making contributions to your pension.
Updated 6 January 2021
Tax relief approaches for different contributions
Income tax relief is available on all pension contributions into registered pension schemes made by or for you while you are under 75 (other than any made by your employer). The relief is available to a maximum equalling your relevant earnings (which includes any income from UK and EEA furnished holiday lettings) or, if more, £3,600 a year.
Schemes established by employers may use net pay arrangements – so deduct tax under PAYE on earnings net of pension contributions.
Contributions to retirement annuity policies are payable gross, with tax relief obtained through the self-assessment return.
Any other contributions are paid after basic rate tax relief by deduction at source, with taxpayers paying tax at higher rates claiming relief at the excess through their self-assessment tax return.
Employers get tax relief on contributions made in respect of their employees, save that, if they are made by a trader, the deduction has to satisfy the 'wholly and exclusively' test. In essence this means it must be made for the purposes of the business (so the contribution should be at a reasonable level for the individual concerned). For more details on the test, see here. Employers may make contributions for employees aged over 75.
Employees are not taxable on their employer's contributions, or on benefits accrued under a defined benefit (final salary) scheme; save where the annual allowance is exceeded – see below.
Different rules apply to those not resident in the UK. Some tax relief is available if, in the previous five tax years, an individual was either resident in the UK or have UK chargeable earnings.
If your relevant earnings are less than the grossed-up pension contributions you make net of basic rate, you will be charged tax at 20% on the excess.
Exceeding your annual allowance
The annual allowance, which applies to pension inputs in a tax year is currently £40,000, or £4,000 once benefits are drawn from a pension scheme.‘
Pension inputs cover:
- contributions to personal pension policies and retirement annuity contracts
- contributions met by deduction from pay
- employers’ contributions to defined contributions schemes and
- benefits accrued in defined benefits schemes met by employers.
The annual allowance for a tax year is increased by any shortfall in your pension inputs in the previous 3 tax years, provided that you were in a registered pension scheme in that earlier year.
The annual allowance is reduced for ‘high-income individuals’. This means someone with ‘threshold income’ over £200,000 and ‘adjusted income’ over £240,000. For these individuals the annual allowance of £40,000 is reduced by £1 for every £2 the adjusted income exceeds £240,000, to a minimum of £4,000.
This taper has applied since 6 April 2016. Before 2020/21 the threshold income figure was £110,000 and adjusted income £150,000 but the minimum was £10,000. By way of an explanation:
- Threshold income is taxable income plus any remuneration ‘sacrificed’ under arrangements entered into after 8 July 2015.
- Adjusted income is taxable income before any pension inputs.
In both cases the income is after various deductions. These deductions include relief for gifts to charity of shares, securities and real property, but (possibly by an oversight) ignoring relief for cash gifts to charity under gift aid.
If your pension inputs in a tax year exceed the limit for that year, you are liable to income tax on the excess at your marginal rate.
The pension inputs in a year in which you die, or retire through severe ill health, are not tested against the annual allowance. They are not limited.
Exceeding the lifetime allowance – in 2020/21 that's £1,073,100
The lifetime allowance will apply on or after you reach pension age and a ‘benefit crystallisation event’ (generally on drawing benefits). A single factor is adopted for valuing defined benefits against the lifetime allowance – it is 20:1 at all ages.
If your pension fund exceeds the lifetime allowance, the excess is subject to a lifetime allowance charge: at 55% if drawn as a lump sum, and 25% if it is retained in the scheme or paid out as income.
Download our detailed guide
For more information on pension taxation and reliefs, download our comprehensive guide, or speak with your Shipleys contact or one of our specialists
Specific advice should be obtained before taking action, or refraining from taking action, in relation to this summary. If you would like advice or further information, please speak to your usual Shipleys contact.
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