Also known as private pension contributions, occupational pension contributions, defined benefit pension contributions, defined contribution pension contributions, final salary pension contributions, money purchase pension contributions.
Tax relief on pension contributions in a nutshell
Individuals can obtain income tax relief on contributions made to a registered pension scheme. The mechanism of tax relief depends on the type of pension scheme. Although, in theory, the individual can contribute up to their relevant UK earnings into their pension scheme in the tax year, if the total contributions exceed the annual allowance, the excess tax relief is clawed back via an annual allowance charge. Employers can obtain corporation tax relief on contributions made to registered pension scheme on behalf of their employees.
Who can obtain tax relief on pension contributions?
To obtain tax relief on pension contributions, the scheme member must be a relevant UK individual. This means that the individual must:
- have relevant UK earnings chargeable to tax in the year (or have earnings from an overseas Crown employment that are taxable in the UK)
- be resident in the UK at some point during the tax year, or
- have been resident when they became a member of the pension scheme and at some point in the last five tax years immediately before the year in which the contributions are paid
Most pension schemes do not allow anyone over the age of 75 to contribute, as no income tax relief is available.
How much can an individual contribute to their pension scheme?
The individual can contribute up to the higher of the following gross amounts into their pension in the tax year:
- £3,600, or
- the amount of their relevant UK earnings chargeable to income tax in the year
Relevant UK earnings include employment income, self-employment income, partnership income and property income from a furnished holiday let.
How does the individual obtain tax relief on the contribution?
The mechanism by which the individual receives tax relief on their contribution depends on the type of scheme:
- relief at source arrangements — the contribution is treated as having been made net of basic rate tax and the pension scheme claims this back from HMRC. For example, a contribution of £800 is a net contribution of £800. The gross contribution is £1,000 (£800 x 100/80). The tax relief at source is £200 (£1,000 – £800). This applies to private pension schemes, which includes group personal pension schemes offered by employers unless the contributions are salary sacrificed
- relief under net pay arrangements — the contribution is made gross and full income tax relief is given via the payroll. This applies to occupational schemes
In relation to relief at source arrangements, if the taxpayer is a basic rate taxpayer, no further adjustment to the income tax calculation needs to be made. However, if the taxpayer is a higher rate taxpayer or an additional rate taxpayer, extra tax relief is given by extending the basic rate band (and higher rate band, if appropriate) by the gross contribution.
For Scottish taxpayers paying tax at a rate above 20%, the relevant tax bands (potentially the Scottish basic rate, Scottish intermediate rate and Scottish higher rate bands, plus the appropriate UK bands where the taxpayer has savings or dividend income) need to be extended by the value of the gross contribution.
Note that there is no income tax charge if the individual has not paid sufficient income tax in the tax year to cover the tax relief at source.
Why do many employers offer to salary sacrifice pension contributions?
Pension contributions made by individuals, whether via relief at source arrangements or relief under net pay arrangements, qualify for income tax relief, but not relief from national insurance contributions (NIC). This means that the employee suffers primary Class 1 NIC on the income used for the pension contribution and the employer pays secondary Class 1 NIC on the income.
In contrast, NIC relief is available for employer pension contributions and such contributions are not taxable benefits. Therefore, many employers offer a salary sacrifice arrangement in relation to employee pension contributions. Under this arrangement, the employee agrees to forfeit an amount of salary equivalent to their contribution to the pension scheme and the employer contributes this amount, together with the usual amount of its contribution for the employee, into the pension scheme.
What is the corporation tax treatment for an employer pension contribution?
Contributions made by an employer to a registered pension scheme in respect of an individual are deductible in computing profits for the period of account in which they are made. They must meet the normal test of having been made wholly and exclusively for business purposes, and there are special rules for spreading relief for abnormally large contributions over more than one period of account.
What happens if the pension contributions exceed the annual allowance?
Although, in theory, the individual can contribute up to the level of their relevant UK earnings and receive income tax relief on this, there is an income tax charge to claw back the excess tax relief if the contributions exceed the individual’s annual allowance.
The amount of the individual’s annual allowance is compared with the pension input amount for the tax year, which takes account of the individual’s contributions and any contributions from a third party (eg employer). The annual allowance charge is found by adding the amount of the excess pension input amount to the individual’s income for the tax year and applying the main rates of income tax to this amount (treating the excess pension input amount as the top slice of income).
Where the annual allowance charge exceeds £2,000, the individual can request that the pension scheme make the payment out of their pension benefits.
The amount of the annual allowance is £40,000. Where the individual’s adjusted income (broadly net income plus all pension contributions) exceeds £240,000, the amount of the annual allowance is reduced by £1 for every £2 of the excess over £240,000 down to a minimum of £4,000.
When an individual is a member of a scheme but during a tax year their pension input amount is less than the annual allowance limit for that year, the unused balance for those years may be carried forward up to three years and used on a ‘first in first out’ (FIFO) basis.
Where the individual has taken pension benefits from a defined contribution or money purchase scheme, their pension input amount cannot exceed £4,000. This is the money purchase annual allowance, which prevents individuals from recycling pension benefits into further tax-relieved pension contributions.