Pensions are the most tax efficient savings schemes due to their ability to avoid or delay the payment of tax. It is still important to weigh up the benefits against their drawbacks to ensure that they are the best option for you.
There are different methods of claiming tax relief dependent upon your circumstances including;
- Applying the conditions
Your pension contributions are made directly on your behalf by your employer with you accepting a lower salary, which is reduced by the level of your contributions, in return.
The key advantage is;
Since employers also pay NICs on employees’ salaries this reduces their costs. The reduction may be passed in part or in its entirety into the employees’ pension schemes
Key disadvantage is;
Pension contributions are made from your net salary (i.e. after tax). Tax is then rebated at the highest rate first. As with salary sacrifice your pension contributions are made gross (i.e. before tax). The difference is that your NICs will tend to be higher under this scheme
Any contribution made into a private pension scheme is automatically increased by the minimum tax relief rate of 20%.
As with all pension schemes you are entitled to receive tax relief at your highest marginal tax rate. Those who pay higher (40%) or additional rate tax (45%) can reclaim the tax paid from HMRC via their Self Assessment Form.
When completing the Self Assessment Form it is important to include the gross contributions made into a pension scheme.
As such, you can reclaim £20 (higher rate) or £25 (additional rate) per £80 pension contribution (i.e. £100 gross) up to the amount you have paid in higher, additional rate tax or a combination of the two
The maximum amount of tax you can reclaim is dependent upon your circumstances though it is a combination of a set minimum, a set maximum based on your income and a set maximum based on a general rule
Any pension contribution made is assumed to have originated from taxed income. The UK Government therefore automatically rebates tax at the lower rate level (20%) known as relief at source. This is done whether or not tax was ever actually paid in the first place.
Therefore, each £80 paid by yourself is £100 gross since the government will have rebated £20 i.e. to account for paying 20% tax
Anyone can contribute up to £2,880 into a pension scheme and receive tax relief irrespective of their income. This equates to £3,600 gross after the minimum tax relief is received
Anyone can contribute up to 100% of their salary per annum and potentially receive tax relief on the full amount. Due to the minimum tax relief and the fact that most people are entitled to receive a personal allowance they can have a pension contribution of 100% of their salary and still have up to 20% income left over.
See the non tax payer example below on how this works in principle
The UK Government has set a maximum level of tax relief claimable per year which is known as the annual allowance. The rate for tax year 2015/2016 is £40,000. In addition, any allowance not used in the previous 3 years can be carried forward with the caveat that you were a UK pension scheme member, which includes qualified overseas pension schemes such as QROPS, in those years.
The annual allowance rate for tax years 2012/2013 and 2013/2014 was £50,000 whilst for tax year 2014/2015 it was £40,000.
This creates an upper limit for claimable annual allowance of £180,000 in tax year 2015/2016 (i.e. £40,000 x 2 + £50,000 x 2)
It is your responsibility to follow the rules concerning claiming tax relief. If you receive a larger tax rebate than you are entitled to then HMRC may demand that you pay penalties on top of refunding the excess tax relief claimed.
As per UK tax rules your annual income is taxable at 20% up to £42,385, then 40% up to £150,000, and 45% from £150,001 onwards. You are entitled to your unused annual allowance from the previous 3 tax years (£30,000 each year) in addition to this years allowance so you can receive tax relief up to £130,000 (40,000 + 3 x £30,000).
From the £50,000 in the pension a further tax rebate of 25% can be claimed on £20,000 (£170,000-£150,000) and 20% on £30,000 (the rest of the gross pension contribution) which totals £11,000 (i.e. 20,000 x 0.25 + 30,000 x 0.2). This is reclaimed via your Self Assessment in the form of a tax rebate and is not added to your pension contribution. As such your net contribution is £29,000 (40,000-11,000)
Your annual allowance is £40,000. You are only entitled to tax relief on £40,000 rather than the £50,000, which is now in your pension. Of that, based on your income, you are entitled to reclaim a further tax rebate of 25% on £20,000 (i.e. £5,000) and 20% on the remaining £20,00 (i.e. £4,000) resulting in a rebate of £9,000.
However, you have already received basic rate tax relief on the full £40,000 i.e. £10,000 when you should have only claimed £8,000 tax relief on £32,000 (40,000 x 80%). The additional tax relief of £2,000 has to be refunded. Your rebate as a result is only £7,000 (9,000 – 2,000) so your net pension contribution is £33,000 rather than £29,000.
The best option would be to contribute £32,000 to your pension which is the maximum allowed under current rules. If you were adamant on contributing the full £40,000 then you could notify your pension provider to ensure they only request tax relief on £32,000. In both cases the additional tax relief would be reclaimed via your self assessment in the same way as above.
If you accidentally contribute in excess of your annual limits you should notify HMRC to repay the difference. Failure to do so may result in HMRC demanding that you repay the excess tax relief along with potential fines.