Contributing to a pension plan is one of the best ways to save for retirement. Not only does it help you build up a nest egg for the future, but pension contributions also come with valuable tax relief that reduces your current tax bill. Understanding how pension tax relief works is key to making the most of this important retirement savings incentive.

What Is Pension Tax Relief?

Pension tax relief refers to the income tax break you receive when you pay into a pension. It encourages saving for retirement by effectively reducing the cost of pension contributions. Tax relief applies to contributions to most registered pension schemes, including workplace pensions, personal pensions, stakeholder pensions, and self-invested personal pensions (SIPPs).

How Does Pension Tax Relief Work?

There are two main ways pension tax relief can work:

• Tax Relief at Source: This is the most common type of pension tax relief. Your pension provider claims the basic 20% tax relief directly from HMRC on your behalf and adds it to your pension pot. So for a basic rate taxpayer, a £100 contribution costs you £80, with the government contributing the extra £20 in tax relief.
• Relief via Self-Assessment: Higher and additional rate taxpayers claim extra pension tax relief through self-assessment tax returns. The additional tax relief reflects your highest marginal income tax rate. So if you pay 40% tax, a £100 contribution costs you £60, with £20 claimed by the pension provider and the remaining £20 reclaimed on your tax return.

The Annual Allowance

The amount of tax relief available is capped by the annual allowance, which is £40,000 in the 2023/24 tax year. This limits the maximum pension contribution you can make each year that will qualify for tax relief. Contributions that exceed the annual allowance will be subject to a tax charge. However, any unused allowance can be carried forward from the previous three tax years.

The Lifetime Allowance

There is also the lifetime allowance to consider, which limits the total amount you can accumulate in pensions over your lifetime while still enjoying tax relief. This stands at £1,073,100 for 2023/24. When benefits are drawn, any amount over this lifetime allowance will be subject to a tax charge of up to 55%.

How Tax Relief Reduces Your Tax Bill

The tax relief you receive on pension contributions helps reduce your income tax liability in the current tax year. Here is an example to show how the savings can add up:

Let’s say you earn £50,000 and contribute £5,000 into your pension this tax year. As a basic rate taxpayer, the £5,000 contribution only costs you £4,000 due to tax relief at source. Therefore, your taxable income is reduced by £5,000, so you pay tax on £45,000 instead of £50,000. With the tax bands and rates for 2023/24, your income tax bill is:

• £12,571 on the first £37,700 of income
• £2,500 on the next £7,300 of income

This gives a total income tax bill of £15,071. Without the £5,000 pension contribution, your tax bill would have been £16,571. So the tax relief has reduced your tax by £1,500 for the year.

For a higher rate or additional rate taxpayer, the savings are even greater due to the extra relief claimed through self-assessment. Pension tax relief is, therefore, an extremely worthwhile tax planning strategy.

Other Ways To Boost Pension Tax Relief

There are steps higher earners can take to maximise pension tax relief:

• Use any unused annual allowance from previous tax years before it expires.
• If paid as a salary sacrifice, make additional employer pension contributions to reduce income taxable pay.
• For the self-employed, contribute before the end of the tax year to benefit in that year.
• Transfer investments to a SIPP to benefit from pension tax relief on future investment growth.

But be aware that reducing taxable income could impact eligibility for certain benefits and tax credits or reduce the amount received.

Tax relief on pension contributions provides a valuable incentive that makes saving into a pension more affordable. For basic rate taxpayers, contributions are topped up by 20% tax relief. Higher earners can claim 40% or 45% tax relief. This reduces your current year’s income tax liability, putting money back in your pocket. By maximising pension tax relief, you can build your retirement savings in a highly tax-efficient manner.

Consult our tax advisors for tax planning and more information on How Pension Contributions Reduce Tax.