August 27th, 2021
How does tax relief work? Your guide to pension contributions
As you may already know, saving for the future is an important part of financial planning. Putting money aside for retirement can help to ensure you have enough income to support your desired lifestyle.
When you’re contributing to your pension, tax relief can be a valuable way of growing your wealth. However, according to a recent study by London Money, published in Money Marketing, less than half of people have a good understanding of how it works.
If you’re one of them, read on to find out everything you need to know about how tax relief can help you save for retirement.
The rate of tax you pay affects how much relief you can receive
To put it simply, the government offers tax relief as a way to encourage people to save for retirement. When you make pension contributions, some of the money that you would have paid in tax is transferred into your pension instead.
The amount of tax relief you can receive depends on how much Income Tax you pay, this means that:
- If you’re a basic-rate taxpayer, you’ll receive 20% tax relief on your contributions
- If you’re a higher-rate taxpayer, you’ll receive 40% tax relief on your contributions
- If you’re an additional-rate taxpayer, you’ll receive 45% tax relief on your contributions.
For example, let’s assume that you pay the basic rate of tax at 20%. In this scenario, if you wanted to make a £100 contribution to your pension, you would only need to put in £80, as the government would add the extra £20.
It’s important to be aware of your allowances to save in the most tax-efficient way
As we mentioned earlier, tax relief can be a useful way to boost your contributions and help you save more for retirement. That’s why it’s important to make the most of your allowances, so you can save in the most efficient way.
There are two main allowances that you need to be aware of: your Annual Allowance and the Lifetime Allowance.
Each tax year (6 April to 5 April), you have a limit on how much you can save into your pension while still being able to benefit from tax relief. This is called your “Annual Allowance” and in the 2021/22 tax year, this amount stands at £40,000 or 100% of your annual earnings, whichever is lower.
Of course, while you can continue to pay into your pension once you hit this limit, you could no longer do so in a tax-efficient way. This is because any contributions over this threshold could incur a charge called the “Annual Allowance Charge”, which essentially claims back any relief that you’d receive over this limit.
The other limit that you need to be aware of is the Lifetime Allowance, which in the 2021/22 tax year stands at £1,073,100. This covers the total value of your private pensions, including:
- Your contributions
- Your employer’s contributions through a workplace pension scheme
- Tax relief
- Investment returns.
When you take benefits from your pension, the Lifetime Allowance will be applied. If the value of your combined pensions is greater than this limit, you may have to pay a charge on the amount above the threshold.
If you take your pension as a regular income, you may be liable for a tax charge of 25% of the excess, or 55% if you take any of the excess as a lump sum.
Your allowance may be reduced if you take benefits while continuing to work
As you may already know, you can access your pension from the age of 55, although this will rise to 57 in 2028. While you can continue to work while taking benefits from your pension, it’s important to be aware that this can impact your allowance.
In this scenario, you may be affected by the Money Purchase Annual Allowance, which can reduce your Annual Allowance down to just £4,000 each tax year.
As you can see, there can be a lot of tax complications to think about when saving for retirement, so if you want to save effectively, you may want to seek professional advice.
Working with a financial planner can help you avoid any potential tax pitfalls, ensuring that you can grow your wealth in a tax-efficient way. This can help to give you a greater sense of confidence that you’ll have enough income in retirement to support your desired lifestyle.
Get in touch
If you want to know more about how a financial planner can help you save for retirement, get in touch. Email firstname.lastname@example.org or click here to request a callback from one of our advisers.
The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Levels, bases of and reliefs from taxation may be subject to change and their value depends on the individual circumstances of the investor.
Workplace pensions are regulated by The Pension Regulator.
This article is no substitute for financial advice and should not be treated as such. To determine the best course of action for your individual circumstances, please contact us.