Tax relief for pension contributions
Tax relief on pension contributions is an aspect of our pension system designed to encourage individuals to save for their retirement. It offers a range of benefits to both employees and self-employed individuals, providing incentives to protect and secure their financial future. Here one of our pension heroes looks at the concept of tax relief on pension contributions and how it works in reality.
The UK Government encourages individuals to save for retirement by providing tax relief incentives on contributions made to pension schemes. The tax relief system operates on the basis that pension contributions are deducted from an individual's taxable income, thereby reducing the amount they earn that is subject to income tax.
The level of tax relief one person can claim on pension contributions depends on their income tax rate. Individuals receive tax relief at the highest rate at which they pay income tax. As an example, for a basic-rate taxpayer in the UK, the tax relief is currently set at 20%, while higher-rate taxpayers receive relief at 40%, and additional-rate taxpayers at 45%.
Let’s look at a basic-rate taxpayer who earns £40,000 per year and contributes £4,000 to their pension. The individual's taxable income will be reduced to £36,000, resulting in a reduction of £800 in their income tax liability. Our pension guardian says that this reduction effectively means that the individual pays £3,200 towards their pension, with the government topping up the remaining £800 in tax relief.
This tax relief is subject to certain limits and conditions however. The annual allowance, which is the maximum amount of pension contributions eligible for tax relief each year, is currently set at £40,000 for most individuals. However, for high earners, a tapered annual allowance system has been introduced, which gradually reduces the annual allowance for those with income above a certain threshold.
There is currently a lifetime pension pot allowance, which is the maximum value of pension benefits an individual can save during their lifetime without incurring additional tax liabilities. This allowance is £1,073,100 in the current tax year, so tax charges will apply on any amounts in excess of this. This is set to change from April 2024 though, so please get in touch to find out which version of the rules best suits your circumstances.
It is important to remember that tax relief on pension contributions is not limited to employees on PAYE. Self-employed individuals can also benefit from tax relief by making contributions to personal pension schemes or, if eligible, the government's Self-Invested Personal Pension (SIPP).
In conclusion then, tax relief on pension contributions is a valuable and cost effective incentive for individuals to save for their retirement, allowing them to maintain a comfortable standard of living in their retirement years.