Pensions and Tax Benefits

If saving for your twilight years does not seem motivating enough then the government is certainly doing its part to make it motivating for you.

Saving in a pension is one of the best ways to build up a retirement income in a tax-efficient manner.

Funds that go into your pension are looked upon leniently by the taxman. But there are annual as well as lifetime limits on how much tax relief you can get.

It pays to plan smartly and choose your options correctly to ensure that you maximize the benefits.

Understanding Tax Relief

In the year 2015-2016, the HM Revenue & Customs (HMRC) provides tax relief on pension contributions up to 100% of your earnings. The upper limit is £40,000.

To simplify things, here’s an example.

  • If you earn £25,000 and you contribute £30,000 into your pension pot by adding additional income sources, then you will only get tax relief on £25,000 (100% of your earnings)
  • On the other hand if you earn £80,000 a year and put the entire amount into your pension pot, you will only receive tax relief on £40,000 (The upper limit)

While you are enrolled in a pension scheme, you can carry forward unused tax allowances from the past three years.

However, if you are enrolled in a Defined Contribution Pension, then according to the new Pension reforms introduced in April 2015, then your contributions can be reduced to £10,000 in some cases.

The Money Purchase Annual Allowance

If a pension scheme member chooses to flexibly access the funds in their pension pot, it triggers the MPAA or Money Purchase Annual allowance which in effect, reduces the annual allowance to £10,000.

This means, if you take the tax-free cash or withdraw funds from the pension pot, you will then receive tax-relief only on £10,000 or 100% of your earnings, whichever is lower.

The MPAA has been drafted to prevent abuse of the flexibility options that a pensioner has.

Some situations in which you may trigger the MPAA are:

  • If you start to make random cash lump sums from your pension
  • If you invest in an income drawdown scheme and start to utilize the income

However, the MPAA limit only applies to defined contribution pensions.

Personal Pensions

If you have enrolled in a personal pension scheme then your income is taxed before your contributions are made into it.

You are eligible to get tax relief on up to 100% of your annual earnings.

The tax relief is automatically applied if your pension provider adds a 20% relief to your pension pot (relief at source).

You can claim additional tax relief if you pay above the basic rate of tax which is 20%.

For example:

  • If you pay 40% income tax, you can claim tax relief on the extra 20%.
  • If you pay 45% income tax, you can claim tax relief on the additional 25%

This claim can be made via a self-assessment form at the end of each tax year.

Company or Workplace Pensions

If you are enrolled in a workplace pension scheme, then the tax relief applicable to you depends on the type of scheme. In most cases, you may not have to do anything and it will all be set up by your employer.

Additional Voluntary Contribution Schemes and Money Purchase Pension Schemes give you instant tax relief as the contributions to the pension fund are paid before the income is taxed.

If you have enrolled in a Salary Sacrifice Scheme, then you will not be eligible for tax relief. But, it allows you to save on income tax and your NI (National Insurance) contributions since you opt for a reduced salary in exchange for contributions to your pension scheme.

Stakeholder and Group Personal Pension Schemes work in the same manner as Personal Pensions do.

Tax Relief for Non-Tax Payers

If you do not earn sufficient income to pay income tax, you can still receive tax relief on any contributions you make towards a pension fund with an upper limit of £2,880.

The taxman will top this up with a 20% contribution making the total amount £3,600. Every penny you add to the pension fund above this amount will be taxable.