How to be tax efficient with your pension contributions

Everyone knows that saving for the future is important, but there is a general apathy towards pensions, one of the single best means of achieving your future lifestyle aspirations. 

This article will benefit people who have heard that pension contributions are tax efficient but don’t entirely understand why.  

What is tax relief?

In simple terms, income tax relief allows you to exclude some of your income from assessment for income tax in exchange for making a pension contribution 

What this means is that if you earn £50,000 but receive tax relief on £10,000 of your income, you will pay tax as though you were earning only £40,000 instead.

At current tax rates, this represents a saving of £2,000 income tax (20% of £10,000).

Clearly tax relief is something everyone should aim for if possible, but it is important to remember that there are limits and restrictions, which will be covered below.

What do I need to do to get tax relief with pensions ?

In simple terms, you need to make qualifying contributions.  

The tax relief available for making pension contributions is a reward from the government for committing money now to look after yourself later in life, making you less likely to need state support in retirement.

How much tax relief can I get?

The amount of personal tax relief you can claim depends on how much you pay into your pension (limited by the annual allowance) and your taxable income.

Relevant Earnings

To work out how much you can pay into your pension, you first need to understand how HMRC will view your earnings. Some examples of the income which does qualify includes:

• Self -employed individual’s profits from the trading year ending in the tax year. For partners, their share of profits
• Employment income (including salary, bonuses, overtime and commissions)
• Benefits in kind
• The taxable part of redundancy payments - the first £30,000 is tax free
• Taxable payments in lieu of notice

Income which does not qualify includes:     

• Dividends
• Savings income
• Rental income
• Pensions in payment
• State benefits

How much can I contribute to my pension?

The government has set an annual cap on the value of contributions, which is called the Annual Allowance. The current Annual Allowance is £60,000. If you have adjusted income in excess of £260,000 or have accessed another pension plan using one of the new flexible income options introduced in April 2015, your Annual Allowance may be lower.

You can contribute up to 100% of your relevant earnings (see above) and, provided your total contributions from all sources (including those made by your employer) do not exceed your Annual Allowance, you will receive income tax relief on your personal contributions.  

If you have income in excess of £200,000 (defined as a high earner) or have accessed another pension plan using one of the new flexible income options introduced in April 2015 your Annual Allowance may be lower¹.

Carry forward facility 

If you do not fund all of your annual allowance this year you are able to carry any unused amount forward to a future tax year (maximum of three years) – perhaps when you have more disposable income available to make a larger pension contribution. 

A note of caution - the rules surrounding the ‘carry forward’ facility can be quite complex and it is best to seek advice before exceeding the standard annual allowance. 

How is tax relief paid?

If you make a contribution to a plan operating relief at source, you make your personal contribution net of basic rate tax and the provider claims the tax relief from HMRC on your behalf.  If you are a higher or additional rate taxpayer, you would apply for extra tax relief through your self-assessment tax return.

Example – Jane wants to make a pension contribution of £10,000 to her pension plan. Under relief at source she would write a cheque for £8,000 to her pension provider. Her pension provider would then claim the basic rate income tax relief of £2,000 (20% of £10,000) from HMRC and apply this to her pension. 

If Jane were a higher or additional rate taxpayer she would apply for extra tax relief through her self-assessment return.

In very simple terms, the gross pension contribution you make expands the band of income which is taxed at the basic rate – it reduces the amount of income which suffers higher or additional rate income tax. 

Example – If we assume that Jane (an English taxpayer) earns £60,270 in the 2024/25 tax year she will have to pay 40% income tax on £10,000 of her salary as this is the amount of income that exceeds both her personal allowance of £12,570 and the basic rate tax band of £37,700. 

By making a gross pension contribution of £10,000 her basic rate tax band of £37,700 is extended to £47,700 which means that all of her income falls within either her personal allowance or the new extended basic rate tax band. This provides an additional income tax saving of £2,000 in addition to the basic rate income tax relief of £2,000 she has already received as she no longer has the higher rate tax liability on that top slice of £10,000. 

So, as a higher rate taxpayer Jane has been able to make a gross pension contribution of £10,000 to her pension and her personal outlay was only £6,000.

Tip

Although most pension providers operate relief at source for personal contribution payments there are other methods of relief available and, depending on your circumstances, you may not benefit from income tax relief on your personal contributions.  

It is best to check this out before you make your contribution. 

What are personal pension contributions?

If you are UK resident and aged under 75, you can make personal pension contributions of up to £3,600 gross per annum. In most cases, these contributions will benefit from basic rate income tax relief.

This includes your children who are eligible to start a pension plan from birth. 

If you want to contribute more than £3,600 to your pension plan then the amount you can contribute (having regard to the Annual Allowance) and claim income tax relief will be limited by your ‘relevant earnings’

What happens to my contributions?

This depends on your pension scheme.

For those of you who are active members of a Defined Benefit scheme, your contributions go towards paying for your accrual of benefits in line with the scheme’s rules – the pension you will receive when you retire.  

Defined Benefit pension schemes are only available from employers and cannot simply be set up by individuals.

Active defined benefit scheme membership is most commonly found in the public sector these days (teachers, civil servants, doctors, for example) and is rare in the private sector.

With a Defined Contribution scheme (the most common type of scheme still open to new members), the money paid into the pension goes into a pot which you usually have investment control over.

You therefore make decisions to invest where you like, subject to the restrictions placed on the scheme by the trustees.

Some schemes will allow only a handful of investment choices, while others allow for hundreds.

This is often where people get overwhelmed by pensions, and it is entirely understandable.  

We all want to enjoy a comfortable retirement and this cannot be achieved if you are reliant on the State Pension alone.

Funding a pension is a tax efficient way of helping you build up another source of income in retirement. 

Can I get my pension contributions back?

A pension contribution can be refunded but only in very limited circumstances. Generally, once you have made a pension contribution you will not be able to access the pension funds until you have reached minimum pension age, which is currently 55 and increasing to 57 in 2028.

As you have read, there are some complicated rules that need to be navigated to ensure that you don’t pay more than the rules allow (there are tax penalties if you do). 

If you would like some guidance on making pension contributions or assistance with making investment decisions within your pension, why not get in touch and arrange a free initial consultation.

Arrange a free initial consultation

References

1. If you think you may have drawn a flexible income or be classed as a higher earner you can find out more about how your Annual Allowance may be affected here.

Investment returns are not guaranteed, and you may get back less than you originally invested. The Financial Conduct Authority (FCA) does not regulate tax advice.