What is pension tax relief?

“Free money? Are you sure?!”

That was the reaction to my explaining pension tax relief recently. It wasn't exactly a sparkling conversation, but I think my friend's mind was sufficiently blown for him to act. "I'm going to take a look at that", he concluded.

It’s sad, though, that so many aren't aware of pension tax relief, the substantial boost to the payments you make into your pension. Almost everyone includes a comfortable retirement as one of their financial goals so countless people are missing out.

It can have a considerable impact on the size of your retirement funds and the income you’re paid. What’s more, it doesn’t matter if you’re not earning or paying tax. If you are a UK resident and under 75, you can still receive some tax relief on pension contributions.

How pension tax relief works in the UK

Currently, anyone under 75 with relevant UK earnings can receive pension tax relief when they make a contribution within the annual allowance to a personal pension such as our SIPP. HMRC adds 20% and any further higher or additional rate income tax relief can be reclaimed – potentially a simple way of reducing your income tax bill for the year.

For example, an investor can claim tax relief on their pension by contributing £8,000 into their SIPP and £2,000 is claimed back from HMRC by the pension provider. A higher rate taxpayer could claim back up to a further 20% via their tax return, reducing the overall cost of the contribution to as little as £6,000. In the same instance, additional rate taxpayers could claim back up to a further 25% making the cost just £5,500 for a £10,000 contribution.

That’s a huge boost to your money right away, and an uplift that would otherwise only come with lots of risk or plenty of time in the market. You can find out more about how a SIPP works here.

Please note that for workplace pensions offering ‘salary sacrifice’ or ‘net pay’ arrangements, all the tax relief, including higher and additional rates, is automatic. That’s because it has the effect of reducing salary, with the specified amount of pay diverted into a pension instead. Similarly, with defined benefits schemes such as final salary pensions there is usually no relief to be claimed because personal contributions are made to the scheme from gross rather than net pay.

Pension contribution rules

The generosity of tax relief does, however, come with limits and there are several rules and regulations with pensions contributions to be aware of. Here’s a breakdown of the main considerations on how much you can contribute to your pension:

• Contributions that attract relief are restricted to 100% of your relevant UK earnings – essentially earned income rather than any other form of income such as dividends or interest.

• Contributions, including those paid by your employer, are also subject to an ‘annual allowance’, which is £60,000.

• Higher earners get a lower annual allowance, which could limit their maximum contribution to as little as £10,000 a year. The rules on when this ‘tapered annual allowance’ kicks in are complicated, but HMRC has more information on how to calculate it here.

• For people who receive ‘flexible’ retirement benefits, such as a flexi-access pension (e.g. pension drawdown or taking more than 25% cash from their pension), a lower annual allowance of £10,000 applies.

• If you haven’t used your full annual allowance from up to three previous years, you might be able to carry it forward and use it in the current tax year provided your earnings are high enough and you have been a member of a registered pension scheme in those preceding years.

• People earning more than £60,000 who wish to maximise pension contributions may be able to take advantage of this. Additional guidance and examples can be found on the government’s money helper website.

Remember, the tax treatment of pensions depends on individual circumstances and is subject to change in future.

Non-taxpayers can benefit too

It is also possible for non-taxpayers to benefit from pension tax relief. In the 2024/25 tax year, individuals under age 75 can contribute up to £2,880 to a pension and receive a further £720, resulting in an overall contribution of £3,600. In addition to upfront tax relief, money in a pension is free from capital gains tax and any income tax.

Is a pension better than an ISA?

For those who need access to their money before retirement (the minimum for pensions being 55 currently and rising to 57), an ISA (Individual Savings Account) offers greater flexibility. At present, pension benefits cannot be accessed until this time, and this minimum age is set to rise in the future. For those choosing a savings vehicle for retirement, the decision is a trickier one. Many investments are available in both ISAs and pensions.

Assuming that investments grow at the same rate in both a pension and a conventional ISA account, in the majority of cases the benefit of upfront tax relief at a person’s highest income tax rate means investing in a pension works out mathematically better. This reflects the fact that pension tax relief on the way in makes an important contribution to overall return. The fact that you can generally take 25% as a tax-free lump sum before drawing the pension also helps.

The main exception to this is for a basic rate taxpayer funding a pension and then becoming a higher rate taxpayer when taking benefits – a situation that could arise if an entire fund is taken in a lump sum, either on purpose or accidentally through poor tax planning. In this scenario, an ISA would produce a better overall return. However, given that it is possible to take periodic income or variable lump sums from pension pots there is scope to plan how to withdraw money tax efficiently.

A further option for younger investors, a Lifetime ISA, can form up to £4,000 of the £20,000 ISA allowance for those eligible. Available to UK residents aged between 18 and 40 saving for retirement or a house deposit, it is possible to pay in up to £4,000 each tax year and continue making contributions up to the age of 50. The government will add a 25% bonus to contributions – a maximum of £1,000 each year – and withdrawals are penalty-free from age 60 or if used for an eligible house purchase.

Take advantage of pension tax relief while it lasts

As it stands today, a pension remains the financially more appealing retirement investment vehicle for most people, including those remaining in the same tax band, or who drop down a tax band or two, once they draw their pension.

However, no one can be sure of pension rules in the future. Tax relief may become less generous, especially for higher earners. For instance, a flat-rate incentive of between 25% and 33% for all pension contributions has been suggested. It may make sense for some people to secure pension tax relief in its current form while it lasts.

The Taxation of pensions is based on individual circumstances and may be subject to change in the future.

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