Skipton Financial Services
Monday, February 22, 2016 - 15:09

How does pension tax relief work?

You may have heard people talk about what a big deal it is, but how does pension tax relief work? Is it really as good as some suggest? And how can you make the absolute most of it?

At its most basic level, tax relief works like this: you agree to commit some of your money into a pension, and the government will waive its usual rate of income tax, thereby topping up your contribution by your rate of income tax.

In plain English, if you are a basic rate taxpayer (20%) this means that for every £4 you pay in, it will be worth £5 when it appears in your pension pot. Clearly, the more that you pay in, the more tax relief you will receive.

It gets even better if you are a higher or additional rate taxpayer, as the rate of tax relief is greater (40 or 45%). You will have to claim for this additional tax relief, but it is well worth doing so, as it could significantly boost your pension savings.

Here are examples of how much tax relief could be worth, depending on your tax status:

 

Gross Pension contribution

Cost of contribution

 

Basic rate taxpayer

Higher rate taxpayer

Additional rate taxpayer

£100

£80

£60

£55

£500

£400

£300

£275

£1,000

£800

£600

£550

What are the downsides?

You can only pay in so much to benefit from tax relief

The maximum you can pay in, if you are a basic rate or higher rate taxpayer, is £40,000 per year (known as your annual allowance). If you have income and pension contributions above £150,000, from April 2016 you may be restricted to pension contributions of  £10,000 per year.

You can, however, carry forward any unused annual allowances from the last three tax years. 

Another important point is you can only receive tax relief on 100% of your net relevant earnings; or, if you’re not earning, £3,600 per year.

You can’t access your pension until you are 55

Thanks to the new pension rules you don’t necessarily have to use pension savings to fund your retirement – it can be for any long-term goal. However, you can’t access your pot until the minimum pension age of 55 which is due to increase in line with the state pension from 2028 – so you must be prepared to commit your capital until you reach that age.

You have to pay income tax on withdrawals

Only 25% of your pot is tax-free to withdraw, the rest is subject to income tax. If you’re a basic rate taxpayer you’ll pay 20% income tax, but if you take too much in one tax year, you might end up paying 40% or 45% on some of your income.

So you will need a careful and considered plan when it comes to accessing your pension pot.

So is tax relief worth it?

It depends on your circumstances and goals for your money, but absolutely it could be worth it.

As a vehicle for saving for long-term needs, pensions stand out as one of the more attractive options because of the considerable tax relief benefits.


The tax treatment of your investments depends on your individual circumstances and prevailing legislation, both of which may change in the future.

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