Tax Relief on Pension Contributions

Pension contributions in the UK come with several tax benefits, but there are also tax liabilities to consider when withdrawing a pension. Here are the key tax benefits, tax-free elements, and allowances available to UK taxpayers. When you contribute to a pension scheme, you receive tax relief on your contributions up to certain limits. For a personal pension or a workplace pension scheme, the tax relief is provided at your marginal income tax rate (20% for basic rate taxpayers, 40% for higher rate taxpayers, and 45% for additional rate taxpayers). This tax relief is provided through the “relief at source” method or “net pay” method, depending on the type of pension scheme. So, for example, if you’re a basic rate taxpayer contributing £80 to your pension, the government adds £20 in tax relief (20% of £100). So your total pension contribution is £100, but it only costs you £80.

1. Annual allowance: The annual allowance is the maximum amount of pension contributions on which you can receive tax relief in a tax year. For the 2021/2022 tax year, the annual allowance is £40,000 or 100% of your earnings, whichever is lower. If you exceed the annual allowance, you may face a tax charge on the excess contributions.
2. Carry forward: If you have not used your entire annual allowance in the previous three tax years, you can carry forward the unused allowance and use it in the current tax year. This can help you maximize your pension contributions and tax benefits.
3. Lifetime allowance: This allowance is the total value of all your pension benefits that can be accumulated without triggering an extra tax charge. The lifetime allowance for the 2021/2022 tax year is £1,073,100. Any pension value above this limit will be subject to additional taxes when you withdraw your pension.
4. Tax-free lump sum: When withdrawing your pension, you can take up to 25% of your pension pot as a tax-free lump sum. The remaining 75% will be subject to income tax at your marginal rate. 

Example: If your pension pot is worth £200,000, you can take £50,000 (25% of £200,000) as a tax-free lump sum. The remaining £150,000 will be subject to income tax.

1. Personal allowance: When you withdraw your pension as income, it is subject to income tax. However, you have a personal allowance, which you can earn each year before paying income tax. The personal allowance for the 2021/2022 tax year is £12,570.

Example: If you withdraw £20,000 per year from your pension, and your allowance is £12,570, you will pay income tax only on the remaining £7,430.

In summary, pension contributions come with tax benefits like tax relief, annual allowance, and the ability to carry forward unused allowances. However, when withdrawing a pension, you must consider the tax-free lump sum, personal allowance, and potential tax liabilities related to the lifetime allowance. To fully understand and optimize your pension tax benefits and liabilities, it’s advisable to consult with a financial advisor or tax professional. You can call us to discuss your personal circumstances with our specialist tax accountants.