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What is pension tax relief and how does it work?

With pension tax relief, you get to keep money you’d normally pay in Income Tax, and instead use it to boost your pension savings. Learn more about what pension tax relief is, how it works, and what its limits are.

What is pension tax relief?

Pension tax relief is a benefit you get for investing into a UK-recognised pension scheme. Essentially, money that you would have paid to HM Revenue and Customs (HMRC) is directed into your pension savings pot – which can then potentially grow in value while it remains invested.1

You can get pension tax relief on all pension types, including workplace pensions, personal pensions, self-invested personal pensions (SIPPs) and stakeholder pensions. How you get this tax relief may differ depending on which of the above pensions you have.

While there’s no limit to how much you can save into a pension over a year, or in total over your lifetime, there are limits on the amount of tax relief you can receive.

To understand how pension tax relief works, it’s worth first taking a quick look at Income Tax marginal rates.

Although certain limits apply, which we’ll discuss, the amount of pension tax relief you can receive aligns with your marginal tax rate bands.

tax relief boost

  Your contribution Tax relief Your pot grows by
Basic rate £80 £20 £100
Higher rate £60 £40 £100
Additional rate £55 £45 £100

The above applies to England, Wales, and Northern Ireland. Scottish Income Tax rates and bands are slightly different to these, but you can still claim pension tax relief at your marginal tax rate.

  • Starter rate and Scottish basic rate taxpayers will both receive 20% tax relief on pension contributions
  • Intermediate rate, higher rate, advanced rate and top rate taxpayers can get pension tax relief at their marginal tax rate(s)

Learn more about pension tax relief in Scotland.

How does pension tax relief work?

There are two ways you can receive tax relief on your pension payments. These are:

  • Relief at source
  • Net pay
For everyone who pays Income Tax, net pay and relief at source are exactly equal in terms of the tax relief you receive – although they work slightly differently.

What is relief at source?

With relief at source, you contribute to your pension scheme from your income after tax has been deducted. Your pension provider will then claim 20% tax relief directly from the government. This amount will be added to your savings.

For example, if you contribute £80 from your after-tax income, your provider will claim £20 from the government on your behalf. Your pension pot will grow by £100.

This 20% tax relief is at the basic rate of Income Tax. If you pay one of the higher marginal tax rates, you can claim this additional tax relief from HM Revenue and Customs (HMRC).

hmrc

If you have a personal pension, the relief at source method will always be used. If you have a workplace pension, your employer may use either relief at source or net pay (see below). Whichever arrangement they use for pension tax relief, it will apply to all employees in the scheme.

What is net pay relief?

With a net pay arrangement, you contribute to your pension scheme from your pay before tax is deducted. Net pay is only used by workplace pensions, and under this arrangement, your employer may offer you ‘salary sacrifice’ (also known as ‘salary exchange’).

Here, your employer will decrease your salary by the amount you’re saving into your pension. This has the benefit of lessening the National Insurance contribution you’re obligated to pay based on your salary. However, there may be disadvantages to using salary sacrifice, depending on your personal circumstances.

By contributing to your pension from your pay before Income Tax is deducted, your pension tax relief is received straight away, and nothing needs to be claimed back from HMRC.

For example, if a £50,000 salary is your only source of income and you pay £10,000 of this into your pension, this entire amount is added to your pot without any deductions. Your taxable income therefore drops to £40,000, minus the Personal Allowance.

If you pay Income Tax above the basic rate of 20% on part of your pay, you don’t have to claim this back from HMRC, as you would with relief at source.

If you earn less than £12,570 and don’t pay Income Tax, the Government will pay a top-up into your pension even if your scheme uses the net pay system.

What are the benefits of pension tax relief?

Tax relief on your pension contributions allows you to invest more money into your pension. To illustrate how much of an effect this can have, compare saving £250 per month over 25 years without tax relief to the same contribution, but with tax relief added.

  Without tax relief With tax relief
Your monthly contribution £250 £250
Tax relief at 20% £0 £62.50
Monthly total £250 £312.50
Total invested into your pension over 25 years £75,000 £93,750
Potential pot value after years** £128,960 £161,200

**Potential pension investment growth over 25 years, at an assumed average annualised return of 4%

Please bear in mind that because investments can fall as well rise, the future value of your pension can never be guaranteed, and the above comparison isn’t based on any product.

What are the limits to pension tax relief?

There are limits to how much pension savings tax relief you can get each year – but remember that these limits only apply to tax relief, and they don’t limit how much you can save into your pot.

The government will use a tax charge to reclaim any relief given on pension savings above these limits.

limits to pension tax relief

The limits to keep in mind include:

  1. Your total income for the tax year
  2. Your annual allowance
  3. The tapered annual allowance, if applicable
  4. The money purchase annual allowance (MPAA), if applicable

Your total income for the tax year

On your own contributions, your pension tax relief is normally limited to an amount equalling up to 100% of your income (referred to as your ‘relevant UK earnings’). This amount includes any contributions made by a third party on your behalf but doesn’t include any contributions made by your employer.

Relevant UK earnings can be your salary or wages, any bonus, interest earned on savings, dividends from shares, profits from a business you own, or rent you earn from tenants living in your property. This list isn’t exhaustive.

If you earn less than £3,600, you can receive pension tax relief on your contributions up to £2,880.

The tax relief limit of 100% of your income won’t apply if you meet or exceed your annual allowance – which will take priority.

What is the pension tax relief annual allowance?

For most people, the pension tax relief annual allowance is £60,000. This means that once all the contributions to your pension savings for the year exceed £60,000, you no longer receive tax relief. However, you can ‘carry forward’, which may mean that you can pay more and still receive tax relief.

This is because carry forward allows you to make use of any annual allowance that you might not have used during the three previous tax years, provided that you were a member of a registered pension scheme during that time.

For a defined contribution scheme, the annual allowance includes:

  • Your own contributions
  • Your employer’s contributions
  • Any other third party who pays into your scheme, and
  • Tax relief already received.

For a defined benefit scheme the annual allowance is based on the capital value of the increase in your pension benefits over the tax year. This information will be available from your provider.

The annual allowance may be reduced for those with an ‘adjusted’ income of £260,000, gradually decreasing to £10,000 for those earning £360,000 or more. This is called the tapered annual allowance.

What is the tapered annual allowance?

The tapered annual allowance gradually reduces the amount of tax relief you’re entitled to if you’re a high earner. Your annual allowance may be tapered if your total taxable income for the year, less your own pension contributions, is £200,000 or more.

If you meet certain other criteria laid out by HMRC, you could see your annual allowance reduced by £1 for every £2 your ‘adjusted’ income is above £260,000. Your adjusted income includes all your taxable income, along with the total contributions made to your pension over the tax year.

The tapered allowance is complicated to calculate, and if you think it might apply to you, we recommend that you to speak to a tax specialist or find a financial adviser.

What is the MPAA?

The money purchase annual allowance (MPAA) is a reduced annual allowance that may apply if you’ve already accessed any taxable pension income from your flexible access drawdown.

The MPAA works in the same way as the annual allowance, but the amount of money you can save into your pension that’s eligible for tax relief is much less. It’s currently capped at £10,000 per year for most people.

If you’ve withdrawn £1 or more of taxable income from your flexi-access drawdown, you might have triggered your MPAA.

Although you should have received a letter from your provider letting you know if you’ve triggered the MPAA, we recommend speaking with an adviser if you’re unsure or would like to know what your options are.

It’s also important to know how to avoid triggering it if you’re thinking of taking money from your pension.

Learn more about the MPAA

Who qualifies for pension tax relief?

To get tax relief on your pension contributions, you need to be an active member of a UK-registered pension scheme, and a ‘relevant UK individual’.

You’re a relevant UK individual if you:

  • Earn an income that’s subject to UK Income Tax. This could include your salary or wages, any interest on savings or investments, or rent. These are all known as ‘relevant UK earnings.’

  • Are resident in the UK at some time during the tax year.

  • Are a Crown employee (or their spouse/civil partner) with earnings from Crown employment.

  • Are a non-UK resident but were living in the UK when you joined a registered pension scheme.

What are relevant UK earnings?

Relevant UK earnings include items like:

  • Your employment income (for example pay, wages, bonus, over time or commission)
  • Interest earned on savings
  • Dividends from shares
  • Profits from a business you own
  • Any redundancy payment you might have received above the £30,000 tax exempt threshold
  • Your benefits in kind from your employer: you can ask your HR department what benefits you’re receiving
  • Your income from a trade, profession, or vocation either individually or in a partnership
  • Rental income from a UK or EEA furnished holiday lettings businesses
  • Income from a patent you hold

This list isn't exhaustive, and tax law can be difficult for a non-specialist to navigate. To ensure that you're maximising your opportunity to receive tax relief on your pension contributions, we recommend speaking with a professional.

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Footnote:

1. Investments can fall as well rise, and you may get back less than you put in. Past performance is not a guarantee of future returns.

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