If you want to know how to use pension contribution to pay less tax, you have come to the right place. We have compartmentalized everything you need to know about tax relief for pension contributions and what you need to do.
| What is pension relief? | Tax goes towards your pension instead of the government |
| How do I avoid higher rate tax UK? | By making pension contributions |
| How much can I save into my pension tax free each year? | £40,000 |
| How much is a lifetime allowance? | £1,073,100 |
What is pension tax relief?
The government rewards you for saving for your pension by adding a percentage to each contribution. The percentage that should have gone to the government as tax comes back to you as a bonus. The bonus is then added to your pension savings. This bonus is your pension contribution tax relief.
How does tax relief on pension contributions work?
You get tax relief at the highest rate of income tax that you pay if you are a UK resident and you are under age 75. This means that basic-rate taxpayers are entitled to 20% pension tax relief and the pension tax relief for high earners to 40%. In comparison, additional-rate taxpayers are eligible for up to 45% pension tax relief.
For instance, if you remit £200 from your salary into your pension account as a basic-rate taxpayer, that amount would cost you only £160. This is because the government contributes a £40 bonus, which would have been deducted in tax from £200 of your salary.
For higher-rate and additional-rate taxpayers, achieving the same £200 pension savings will set you back only £120 and £90, respectively.
Do pension contributions reduce your taxable income?
Pension contributions are free of income tax. However, pension contributions do not necessarily reduce your overall taxable income. This is because the higher you earn, the higher the rate of income tax you might be required to pay.
However, ‘a salary sacrifice arrangement’ is how to use pension contribution to pay less tax. A salary sacrifice arrangement is an agreement between you and your employer which involves your employer reducing your salary by a certain amount and remitting that amount to your pension savings. By forfeiting some of your salary, you get paid a lesser amount. Consequently, this forfeit reduces what you’ll have to pay in income tax and national insurance, resulting in a higher take-home pay.
How much can I save into my pension?
There are limits on how much you can contribute to your pension account in a tax year and how much your pension pot can contain in a lifetime. In a single tax year and according to the UK tax year dates 2022, the maximum amount you can contribute to pensions and still remain eligible for tax relief is £40,000.
The lifetime allowance limit is £1,073,100. A lifetime allowance is the most you can access from pensions in your lifetime without incurring extra tax charges. You can surpass this limit, but it will cost you an additional 25% tax if you receive it as income and a whopping 55% if you receive it as a lump sum.
How does this work for non-taxpayers and low earners?
Non-taxpayers can also get a tax relief of 20% without paying any taxes. If you’re a low earner, you can divert all your income to your pension savings to get tax relief, as long as the amount is less than or equal to £40,000 in a year. However, note that for an income bracket of £3,600 or less, your contribution is capped at £3,600.
What if I don’t earn an income at the moment?
If you’re currently out of employment, you can also contribute a maximum amount of £3,600 to get tax relief. Higher amounts contributed will not attract any additional tax relief on your pension.
How to claim your pension tax relief?
Tax relief on pension contributions is claimed either through ‘relief at source’ or ‘net pay’, depending on whether you’re in a personal pension or in a workplace pension. Both methods provide how to use pension contributions to pay less tax.
Pension tax from relief at source
Pension Relief at source is used for all personal pensions, whether your pension provider is an insurance company or if you have a SIPP. You can also use a SIPP for some workplace pensions.
With the tax from relief at source method, after tax is deducted from your taxable earnings, 80% of your pension contribution is deducted from your net salary and remitted to your pension provider. Your pension provider then sends a request to HMRC to claim 20% in tax relief which is added to your pension.
If you pay higher than 20% in tax, you would be required to complete a self-assessment tax return to access your extra tax relief.
Net Pay Pension Tax
Net pay arrangement is the method of choice for most workplace pensions. Here, your pension contributions are deducted fully from your salary before you are taxed. So, you pay tax on the balance of your earnings after your pension contribution. With this method, it doesn’t matter what rate of tax you pay because you get full relief immediately without needing to claim it.
FAQ
Do pension contributions reduce taxable income?
Yes, if you save money into a pension, you’ll pay less income tax. If you are a higher-rate taxpayer and save enough, you can escape 40pc tax entirely. The downside, of course, is that your take-home pay is lower, and you can only withdraw any money held within your pension at age 55.
Can salary sacrifice lower my tax bracket?
Yes, by giving up some of your salary, the total amount you earn is reduced, which reduces the amount of income tax and National Insurance you pay. However, this action can increase your take-home pay.
What are the requirements to receive tax relief?
If you’re a UK taxpayer under 75 years old, you can claim tax relief on pension contributions (up to 100% of your income) or contributions up to £40,000 per annum.
*Capital at risk. Tax treatment depends on your individual circumstances and may be subject to change in the future.
