The Ultimate Guide to Pensions and Tax

Tom Carter

by , Social Media & Content Manager

at PensionBee

20 Mar 2020 /  

Black drawer filled with brightly coloured folders

A pension is one of the most tax-efficient ways to save for your future.

This is due to the government encouraging pension saving by providing tax benefits. HMRC will provide a top-up on every personal contribution you make and although there are certain limits and rules that govern this tax relief, it’s not as complicated as it may seem.

Our straightforward guide will tell you everything you need to know about pensions and tax, from contribution limits to the tax-free lump sum at retirement.

How does tax relief on contributions work?

One of the best things about saving into a pension is the tax relief you get on your contributions. If you’re under the age of 75 and you have UK earnings (or you’re a UK resident for tax purposes) you can contribute to a pension and receive pension tax relief.

Tax relief on personal pension contributions

For each tax year, you can get pension tax relief on personal contributions up to 100% of your annual salary, capped at a maximum of £40,000 (2020/21). This limit is the “gross” pension contribution, meaning it includes the top up that’s added by HMRC. If you don’t earn anything, the maximum contribution you can receive tax relief on is £3,600 gross.

For example, if you are a basic rate taxpayer and you were to pay £8,000 into your pension fund, HMRC will have added an extra £2,000 in tax relief, meaning a total of £10,000 in savings for your pension. So for every £4 you add to your pension, the government effectively adds £1 as a tax top up.

All UK taxpayers will automatically receive the 25% pension tax relief, but higher rate and additional rate taxpayers can then claim an additional 25% and 31% tax top up via their Self-Assessment respectively. You will only be able to claim back this tax relief from the last 4 years though.

How do company contributions work?

A pension set up by your company during your employment is often referred to as a ‘workplace pension’. All employers are required to provide a workplace pension scheme, as part of ‘Auto-Enrolment’, and are required to contribute to it if:

  • You’re classed as a worker
  • You’re older than 22
  • Have a minimum annual salary of £10,000
  • Usually work in the UK

Tax relief on employer pension contributions

You will pay a percentage of your earnings into the pension scheme straight from your salary, and your employer is also required to contribute to your pension. Although your employer contributions aren’t eligible for tax relief it is effectively free money adding to the value of your pension.

Our section on workplace pensions provides more information.

Salary sacrifice pension tax relief

Some employers also offer the ability to pay pension contributions through salary sacrifice. The employee reduces their earnings by the amount they would have paid into a pension and then the employer pays the total contributions. Tax relief cannot be claimed in this situation as the employee has been taxed on a lower amount of salary already.

However, as the employee is effectively receiving a lower salary there are savings on National Insurance contributions.

How much can I contribute to my pension?

It’s important to save as much as you can in preparation for your retirement, however there is such a thing as too much with regards to your pension contributions.

As mentioned earlier, for each tax year you can get tax relief on pension contributions up to 100% of your annual earnings (“Net Relevant Earnings”), up to a maximum of £40,000. This limit is the “gross” pension contribution, meaning it includes the top up that’s added by HMRC.

If you earn less than £3,600, or you don’t earn anything at all, you’re still allowed to receive tax relief on contributions up to £3,600 gross. That means you can save up to £2,880 net plus a 25% tax top up.

Annual Allowance

As well as there being a limit on tax-relievable personal contributions, there is a limit on the total contributions which can be made into your pension in any given tax year called the “Annual Allowance” which is currently £40,000 (2020/21). Effectively this means that the total of your employer contributions + personal contributions + HMRC top ups cannot exceed £40,000 across the tax year.

If you want to save more into your pension, which would take you over the annual allowance, you’ll have to pay an ‘annual allowance charge’, which is a tax on the amount you go over by. You can use our pension calculator to work out how much you should be saving and help you to plan for your retirement.

There is also a tapered allowance for high earners. This will only affect you if you earn more than £240,000, including pension contributions (called your ‘adjusted income’), and more than £200,000 excluding pension contributions (known as your ‘threshold income’). This means that for every £10,000 you earn over £240,000, your allowance is reduced by £5,000, right down to an allowance of just £4,000 for those who earn over £312k.

Carry Forward Annual Allowance

If you’re set to exceed your annual pension contribution allowance for the current tax year, you may be able to use some unused allowance from a previous tax year. You can carry forward allowances from the last three years, as long as you were a member of a registered pension scheme during those years.

The annual earnings limit still applies, so even if you’ve carried over a previous year’s allowance, your tax-relievable contribution limit is still capped according to your annual earnings. Employer contributions are not limited by earnings however would still need to pass the “wholly and exclusively” test.

Money Purchase Annual Allowance

It is also worth noting that once you have started drawing down the taxable cash from your pension, there will be a restriction on the amount you can continue to contribute to your pension. The current ‘Money Purchase Annual Allowance’ is £4,000 (2020/21). If you exceed this £4,000 limit, you will face a tax charge in line with your marginal rate of income tax.

What is the lifetime allowance?

As well as the annual allowance, there’s a lifetime limit on the amount of pension that can be drawn before different tax rules kick in. The lifetime allowance is the amount that you can save into your pension, without triggering a significant tax charge when you come to retire. This lifetime allowance is currently capped at £1,073,100 for 2020/21, but this is set to increase in the future.

If you exceed this limit, you’ll be subject to an immediate tax whenever you take the excess benefits from your pension. You will be charged 25% if it’s paid as a pension or 55% if paid as a lump sum, plus income tax at your standard rate.

As the lifetime allowance has been reduced slightly over time, some savers with pensions over £1 million can get protection from the reduction in lifetime allowance. This is more common for people who were saving when the limit was higher. You would need to apply to HMRC for this protection.

When can I take the money out of my pension?

The current age at which you can access your personal or workplace pension is 55, however there is talk of this increasing to 57 by 2028. In contrast, you won’t be able to claim your State Pension until your late 60s.

The only exception to being able to access your personal or workplace pension before 55 is due to ill health. For instance, if you have a life expectancy of under 12 months or are no longer able to work due to illness, then you may be able to drawdown from your pension before the age of 55.

It’s important to remember that your pension is there to support you for the duration of your retirement, and not just your immediate future - it isn’t a necessity to start drawing down from it once you reach 55. You can choose to continue working or delay taking your pension and officially retire whenever you want, which can help to boost the income you will receive. You can use our drawdown calculator to help you plan for this and get a better understanding of what you will be able to withdraw in your retirement.

Pension Drawdown Tax

Although pensions are very tax-efficient, you will face some income tax on your pension. When accessing your pension fund you can withdraw the first 25% tax-free, and it doesn’t matter how large your pot is or what you plan to do with the money. However, any withdrawals over the 25% threshold will be subject to income tax known as pension drawdown tax.

Will pension lump sums be taxed?

It’s quite common that people will take the first 25% of their pension as a lump sum upon reaching retirement age, with this amount being tax-free. The other 75% of your pension is subject to income tax whether you decide to take it as a lump sum or in smaller amounts.

Your pension is viewed in the same way as any other income you receive by HMRC. You will be charged your usual rate of 20%, 40% or 45% income tax, once you’ve used your tax-free allowance (£12,500 from 6 April 2020).

If you’re still working, or receiving other income, you may want to consider the timing and size of each lump sum withdrawal, as it could push you into a higher tax bracket.

Pension Credit

Some pensioners on low overall incomes will also be eligible to ‘Pension Credit’. This is an income-related benefit that is made up of 2 parts - ‘Guarantee Credit’ and ‘Savings Credit’.

Guarantee Credit is used to top up your weekly income, if your income is less than £173.25 for a single person, or £265.20 for a couple (2020/21). Whereas, Savings Credit is an additional payment for people who have saved some money towards their retirement already, for example a pension. It’s also worth noting that you won’t pay tax on your Pension Credit.

How do you make the most of pensions tax relief?

Maximise your annual tax relief allowance

It’s important to check that you are getting the maximum tax relief possible. UK Taxpayers will always receive the 25% tax top up from HMRC. However, if you’re a higher rate or additional rate taxpayer, it’s important that you are claiming your further entitlement through your Self-Assessment tax return, as you could be missing out on thousands of pounds.

We recently carried out research on unclaimed tax relief and found that around 80% of higher rate taxpayers and 54% of additional rate taxpayers aren’t claiming all the tax relief they are eligible for. This is hundreds of millions of pounds just sitting there in unclaimed tax relief!

Carry forward some of your annual allowance

If you’re set to exceed your annual pension contribution allowance for the current tax year, you may be able to use some unused allowance from a previous tax year.

You can carry forward allowances from the last three years, as long as you were a member of a registered pension scheme during those years. The annual earnings limit still applies, so even if you’ve carried over a previous year’s allowance, your tax relievable pension contribution limit is still capped according to your annual earnings. For example, if you have an annual salary of £50,000 and you’ve already contributed your annual allowance of £40,000 for the year.

However, if last year you only contributed £25,000 to your pension, this would mean you have £15,000 of unused annual allowance you would be able to carry forward. So, this means that you could contribute an additional £10,000 gross into your pension before 5 April and still get tax relief on this extra amount.

Make contributions from your limited company

If you run your own limited company, you can make employer contributions through your company. These can be treated as an allowable business expense, meaning they can be offset against your corporation tax bill. With current corporate tax rates at 18% (2020/21), if you make a £10,000 pension contribution, you would save £1,800 in corporation tax.

It is also worth bearing in mind that employers don’t have to pay National Insurance on pension contributions, so by contributing to your pension rather than paying the equivalent in salary, you could save nearly 14% in National Insurance Contributions.

This means you could make a saving of over 30% by contributing to your pension instead of taking the money in the form of salary.

Withdrawal tax with PensionBee

When you choose PensionBee to manage your pension we’ll take care of the tax for you. It’s easy to make a withdrawal through your BeeHive - your online dashboard - and we’ll tell you how much pension drawdown tax you’ll need to pay upfront.

Every time you make a withdrawal we’ll use Pay As You Earn (PAYE) to deduct the tax you need to pay, before releasing your funds to your bank account. Find out more about drawdown from PensionBee today.

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