Tax might not be the most exciting subject, but there’s a few things about pension tax that’s helpful to know. It’s important for employers to set up tax relief correctly – so that their employees get tax back on the money they pay into their pension. And it’s also important for employees to understand the tax implications when they come to take their money out of their pension.
With the 5 April end of tax year approaching, we answer our members’ most frequently asked questions about pension tax.
Do you pay tax on your pension?
You don’t pay tax on your pension contributions (when you pay money into your pension pot). In fact, the government actually gives you tax back as tax relief. So the tax you’d normally pay goes into your pension savings instead.
When you come to take money out of your workplace pension to live on in later life, you get a quarter of it tax free – but you’re subject to tax on the other three-quarters of the money you take out. So it pays to understand how tax works when taking money out of your pension – and how the way you take your pension money effects how much tax you’ll pay.
Pension tax: when paying in
To help you save for your retirement, the government provides tax relief on the earnings you put into your pension pot. So the tax you’d normally pay goes into your pension savings instead.
Pension annual allowance
If you’re saving a lot into your pension, it’s worth noting the annual allowance of how much you can save into your pension each year and get tax relief on.
The standard limit is currently £40,000 – across all of the pension schemes you belong to.
This allowance may be reduced when you take money out of your pension. Depending on how you take your pension savings, your money purchase annual allowance (MPAA) might be triggered.
Carry forward pension annual allowance
If you go over your annual allowance limit, you’ll normally have to pay tax on the excess – but in some cases you can carry forward any unused annual allowance from the previous 3 tax years, which may reduce the tax charge.
To use carry forward, contributions must exceed your annual allowance in the current tax year (the standard annual allowance is currently £40,000). You’re then permitted to use any unused tax relief from the preceding 3 tax years, starting with the tax year 3 years ago.
You’ll need to meet 2 conditions to use carry forward:
- You must earn at least the amount you wish to contribute in total in the current tax year (unless your employer is making the contribution). For example, if your earnings are £50,000 – you can only contribute up to £50,000 and get tax relief on this.
- You must have been a member of a UK-registered pension scheme (this does not include the state pension) in each of the tax years from which you wish to carry forward.
You can use the pension annual allowance calculator on the government’s website to see how much you can carry forward, or check if you have an annual allowance tax charge.
Pension lifetime allowance
There’s also a limit on how much you can pay into a pension in total over your lifetime.
Your lifetime allowance is the total amount of all your pension savings (apart from your State Pension) that can be built up over your entire working life without triggering an extra tax charge. At the moment the standard lifetime allowance is £1.055m.
Some people may have registered for protection with HMRC in the past, but otherwise, if you think you might go over this limit you should get financial advice.
Pension tax relief
How tax relief works for employees
When your employer sets up your workplace pension, they have to choose 1 of 2 methods for how you get your tax relief.
One method (gross tax basis) takes your pension contributions from your pay before your wages are taxed, which means you only pay tax on what’s left so you get your full tax relief straightaway, unless you don’t pay tax.
The other method (net tax basis) takes your pension contributions after they’re taxed. Then we automatically claim tax relief for you, adding the basic tax rate of 20% to your pension contributions. If you live in Scotland and you pay the Scottish starter rate of tax at 19%, we’ll still give you tax relief at 20% and you won’t have to repay the difference. If you live in Wales, your tax rates and allowances are currently the same as England and Northern Ireland.
If you pay the basic rate of 20% tax…
If you’re a basic-rate taxpayer, you don’t need to do anything – you’ll always get tax relief on your workplace pension contributions automatically (regardless of which tax relief your employer uses).
If you pay higher rate tax…
If you’re a higher rate taxpayer, it depends on how your employer set up your workplace pension – and which tax relief method they use.
If your pension contributions are taken after tax, you get the first 20% tax back automatically, then you can claim the rest from HMRC in your tax return.
If you don’t pay tax…
If you don’t pay tax because your earnings are below the annual income tax personal allowance, it depends on how your employer set up your workplace pension – and which tax relief method they use.
If your pension contributions are taken before tax, you will not benefit from the tax relief that a taxpayer would receive, and you cannot claim any money back from HM Revenue & Customs (HMRC). You still need to contribute at least the same minimum amount that taxpayers have to contribute into their pension pots.
So for example, if your minimum pension contribution by law was meant to be £10 a month, your employer would take the full £10 a month from your wages. However, you’ll still continue to benefit from the money that your employer pays in to your pension pot.
If your pension contributions are taken after tax, the government will still give you tax relief at the basic tax rate of 20% as follows:
- If you don’t have any earnings, or you earn up to £3,600 a year, you can pay in up to £2,880 every year and the government will top up your contribution with tax relief to make it £3,600.
- If you earn more than £3,600, you can pay in up to 100% of your earnings and receive tax relief (up to the annual allowance) every year. The annual allowance for the current tax year is £40,000.
What if I make extra pension contributions by Direct Debit?
These will automatically have tax relief added – at the basic tax rate of 20%.
How do I check which tax relief method I’m on?
Ask your employer whether your pension contributions are taken before or after your earnings are taxed.
Is net pay before or after tax?
‘Net pay’ means the amount you’re paid after tax has been taken.
That’s why we call it a ‘net tax basis’ when we take pension contributions after tax – because that would mean we’d be taking your contributions from your ‘net pay’.
Your ‘gross pay’ is the amount you’re paid before tax is taken.
So when we take pension contributions before tax, we call it ‘gross tax basis’ – because that would mean we’d be taking your contributions from your ‘gross pay’.
What employers need to know about auto-enrolment tax relief
The government gives tax relief to employees on the amount of money they contribute to their pension pots.
So when you set up your pension scheme, you have to choose 1 of the 2 tax relief methods available:
- You can either set it up so your employees’ contributions are deducted from their wages after tax. We call this the net tax basis. You may see HMRC referring to this as the ‘relief at source’ method. When you sign up to The People’s Pension, we’ll automatically set you up on the net tax basis.
- Or you can set it up so your employees’ contributions are deducted from their wages before tax. We call this the gross tax basis. You may see HMRC referring to this as the ‘net pay arrangement’ method. If you choose this option, you’ll need to call us on 01293 586666 to set this up.
How to set up tax relief correctly
Getting tax relief right is essential.
You need to check that you’ve applied the same tax relief settings to your employees’ pension contributions on your payroll and on your pension scheme. If you use a different method on your payroll to the way your pension scheme has been set up with us, it’ll mean more work and additional submissions to HMRC.
HMRC are becoming more vigilant in monitoring tax relief – in some cases revealing and fining employers who have managed tax relief incorrectly. Also, if the tax settings are incorrect, it could mean that the contributions are less than the minimum legal requirement.
When you sign up, we’ll ask you to confirm that your payroll has been set up to deduct employee pension contributions on the correct tax basis. We’ll also ask you to check and confirm you understand the tax basis every year.
Net tax basis (deducting contributions after tax)
Net tax basis is the default tax relief method with The People’s Pension. So we’ll automatically set you up on this arrangement when you sign up to The People’s Pension. HMRC call it ‘relief at source’.
Net tax basis is great for lower paid employees:
- Under this tax basis you’d deduct employee contributions from their pay after tax is taken. (That’s why we call this tax basis net.)
- Then, The People’s Pension claims the tax relief – at the basic 20% rate of tax – from the government. If any of your employees are Scottish taxpayers and they pay the Scottish starter rate of Income Tax at 19%, we’ll still give them tax relief at 20% and HMRC won’t ask your employees to repay the difference.
- And it’s then added to your employee’s pension savings.
If your employees don’t pay tax as their earnings are below the annual standard personal allowance (£12,500), they’ll still get tax relief on their pension contributions at the basic rate of 20% as follows:
- If they don’t have any earnings, or they earn up to £3,600 a year, they can pay in up to £2,880 every year and the government will top up their contribution with tax relief to make it £3,600.
- If they earn more than £3,600, they can pay in up to 100% of your earnings and receive tax relief (up to the annual allowance) every year. The annual allowance for the current tax year is £40,000.
If any of your employees pay more than the basic rate of tax, they can claim the extra tax direct from HMRC through their tax return.
Here’s an example of how net tax basis works in practice…
Mike doesn’t earn enough to pay tax. £8 goes from his wages into his pension pot. Then The People’s Pension claims 20% in tax relief, adding an extra £2 to Mike’s pension pot – the same 20% rate as a basic rate taxpayer.
Gross tax basis (deducting contributions before tax)
Pension contributions taken under the ‘net pay arrangement’ are actually taken from the gross pay, not the net as HMRC’s title suggests! So we call it the gross tax basis instead.
Gross tax basis works well if all your employees pay tax:
- Under this tax basis you’d deduct employee contributions from their pay before tax is taken. (That’s why we call this tax basis gross.)
- So, your employees will automatically get full tax relief on their contributions straightaway, regardless of the band or rate of tax they pay, or whether they live in Scotland, Wales or elsewhere in the UK.
- But unlike the alternative net tax basis, it means lower paid employees who don’t pay tax won’t receive any tax relief.
With the gross tax basis, employee contributions are deducted from their pay before any tax is taken. So if they pay more than the basic rate of tax, they get the full tax relief straightaway.
Here’s an example of how gross tax basis works in practice:
John normally pays the basic 20% rate of tax. £50 goes from his wages into his pension savings, before any tax is taken from his pay. This reduces his taxable earnings by £50 so he pays £10 less in income tax.
However, any employees earning less than the standard personal allowance of £12,500 a year (for the current tax year) won’t receive tax relief because they don’t earn enough to pay tax.
Not sure which tax relief basis to choose?
You can call us on 01293 586666.
Want to change your tax relief settings?
Email us at firstname.lastname@example.org.
How much tax relief will your employees get?
Tax relief is available on employee’s pension savings up to a standard limit known as the annual allowance, but their exact annual allowance depends on how much they earn. The annual allowance includes all their pension contributions, tax relief and their employer’s contributions (across all their pension arrangements). The annual allowance for the current tax year is £40,000 – but those employees who’ve already taken any money out of their pension savings may have a lower annual allowance.
Under HM Revenue & Customs (HMRC) rules, each tax year your employees can receive tax relief on 100% of their relevant UK earnings (up to the annual allowance) or £3,600 gross (£2,880 net)* – whichever is higher. Relevant UK earnings are those earnings which are subject to UK income tax. If your employees are classed as Scottish tax payers, they’ll pay different tax rates to that of the rest of the UK. For more information please visit HMRC’s webpage on the Income Tax in Scotland. Please note, if your employees are classed as Welsh tax payers, their tax rates and allowances will be the same as England and Northern Ireland.
Don’t forget to include your employees’ National Insurance numbers when submitting your data. Without their NI numbers, your employees (under HM Revenue & Customs rules) won’t be able to get tax relief on their contributions. To find out more on why you need to include all your employees’ NI numbers visit our help and support.
*Due to the way tax relief works on workplace pension schemes, those whose earnings are below the standard personal allowance of £12,500 can only receive tax relief if they pay into a scheme which is set up on the ‘net tax basis’ (see above).
More information about tax relief
Pension tax: when taking money out
Each time you take a pension pot, 25% of it is tax free.
You’re taxed on the rest (75%) as you would be with other earned income, like a salary. (But you don’t pay national insurance on it.)
Please note – for most people, 25% of your pension pot is tax free. In a few cases, you might get more than 25% tax free if you’re eligible for protected tax-free cash – but it’s quite uncommon. If this is the case for you, we’ll let you know when you take money from your pension pot with us. You can find out more about this on our help and support pages.
What tax rate applies?
Payments from the other 75% of your pension pot are classed as ‘earned income’ for tax purposes – which means you’re taxed at the highest rate of tax you pay.
How is my pension tax calculated?
Your tax is calculated on a yearly basis, so it depends on how much income you’ve received in that tax year. (The tax year runs from 6 April to 5 April.)
So whether you’re taking your pension:
- all in one go
- a bit at a time, or
- as a guaranteed income…
…it’s important to consider whether adding the payment(s) to your other income could push you into a higher tax band for that tax year (meaning that you could pay more tax than usual).
What is emergency tax?
Emergency tax applies when HMRC haven’t given your pension provider your tax code yet, so a temporary tax code is applied instead.
You’ll sometimes see it called an ‘emergency month 1’ tax code because it’s treated like your first month of income for that tax year.
The reason you can end up paying lots of tax when you’ve got an emergency tax code is – it’s assumed that you’ll be paid the same amount every month for the rest of the year.
Emergency tax on your pension lump sum
When you start taking money out of your pension pot, with some of your options, it’s likely that you’ll be allocated an emergency tax code to begin with.
So the lump sum(s) you take may be taxed using an emergency rate until HM Revenue & Customs (HMRC) have given your tax code to your pension provider. This can sometimes happen again in future tax years.
So you may pay too much tax at times – but if you do, you’ll be able to claim a tax refund from HMRC.
Or, if you choose to take a pension pot of £10,000 or less all in one go (as a small pot lump sum), your pension provider will normally deduct basic-rate tax. Basic rate tax is currently set at 20%.
So if you pay a different rate of tax, you’ll either be due a refund from HMRC or you may need to pay further tax.
Tax relief after you’ve taken money out
Money purchase annual allowance (MPAA)
Normally, you receive tax relief on the money you pay into your pension pot.
There’s a limit to how much you can put in and still receive tax relief on – this is called the annual allowance.
Your allowance applies across all of your pension pots and schemes. It includes all of the contributions that you and your employer (or anyone else) pays into your pension, as well as any tax relief that’s added by the government.
When you start taking money out of your pension savings, this limit may go down, depending on which option you choose to take your pension pot through.
- Before you start taking your pension savings, your annual allowance means you can pay up to £40,000 (…for most people – but for some, it works a bit differently – find out more about your annual allowance on our help and support pages).
- Once you start taking money from your pension (under some options), you won’t be able to pay more than £4,000 a year into defined contribution pension schemes (like The People’s Pension) and still receive tax relief. This is called your money purchase annual allowance (MPAA). And if you pay more than your MPAA into a pension, you will have to pay a charge.
It’s important you think about your MPAA if you want to continue paying into a pension after you start taking money from your pension pot.
Other tax rules around continuing to save
There are other HMRC rules about continuing to pay into a pension pot after you’ve started taking money out of your pension savings – particularly to stop you from taking your 25% tax-free cash and then putting it straight back into another pension. If you pay your tax-free lump sum back into a registered pension scheme, there could be serious tax consequences and other charges to consider.
Your pension provider will let you know if you withdraw savings from your pension pot in a way that triggers your MPAA. Then you’ll have 91 days to let any other providers you’ve got pensions with know.
Your pension provider should warn you about these rules when they apply to you – but it’s also a good idea to get guidance on this from Pension Wise (a free government service).
And you might want to get specific advice from a financial adviser – you can find an adviser who specialises in retirement planning on the Money Advice Service website.
Which options will trigger your MPAA?
Will the amount I can save into a pension and get tax relief on go down if I…
|…keep my pension pot where it is?||No||Leaving your money in your pension pot won’t trigger your MPAA.|
|…take a pension pot of £10,000 or less all in one go (as a small pot lump sum)?||No||Taking a pot of £10,000 or less all in one go as a small pot lump sum won’t trigger your MPAA. But to take your pension pot with us in one go as a small pot lump sum – you (and your employer) must have stopped paying into it.|
|…take a pension pot of more than £10,000 all in one go?||Yes||Taking a pot of more than £10,000 all in one go will trigger your MPAA.|
|…take my pension pot a bit at a time – taking my tax-free cash gradually?||Yes||From the first lump sum.|
As soon as you take the first lump sum from your pension pot, your MPAA will be triggered.
|…take it a bit at a time – taking my tax-free cash up front?||Yes||But not to begin with.|
The initial 25% tax-free cash won’t trigger your MPAA. But it will be triggered once you start taking lump sums from the remaining amount.
|…buy a guaranteed income (‘annuity’)?||Maybe||In most cases, buying a guaranteed income won’t affect the amount you can pay into a pension pot and get tax relief on.|