As the influential psychologist B. F. Skinner theorised, behaviour is determined by its consequences, be they rewards or punishment. And it is this theory that appears to have driven the UK Government’s pension tax relief policy.
Put simply, pension tax relief is a reward from the Government for saving for one’s future. This means that when an individual pays into a pension, a portion of the money that would have gone to the Government in tax goes into their pension pot instead.
Whilst many savers are aware of the benefits of pension tax relief, few are aware of how it works in practice. And it is important to know the greater details of the policy, otherwise, savers could find themselves facing some unexpected charges…
How does it work?
A person receives tax relief whenever they contribute to their pension; the tax relief is paid at the highest rate of income tax an individual pays.
This means that base-rate taxpayers (those earning between £12,501 and £50,000) receive 20% pension tax relief. Meanwhile, higher rate taxpayers (earning £50,001 to £150,000) receive 40% and additional rate taxpayers (earning over £150,000) 45% tax relief on their pension contributions.
To offer a practical example, if a basic rate taxpayer wanted to contribute £100 into their pension, the Government would pay an additional £20 into their pot, on top of the contribution, instead of taking away £20 as tax. Similarly, the Government would top up high and additional rate taxpayer contributions by £40 and £45 respectively.
Claiming tax relief
There are two methods of claiming tax relief. The first is pension tax relief from “net pay”, which is used by the majority of workplace pension schemes. With this method, very little action from the saver is required – the pension contribution is deducted from an individual’s salary, and the Government automatically tops up their pension pot in accordance with their highest rate of income tax.
The second method is pension relief “at source”, which is used by personal pensions and some workplace pension schemes. For basic rate taxpayers, this is fairly straightforward: an individual pays 80% of their desired contribution (personally or via their employer), and then their pension provider sends a tax relief request to HMRC. This is subsequently added to their pension pot.
However, under this system, higher and additional rate taxpayers must complete a self-assessment tax return, in order to receive the relief they are owed.
Is there a limit to pension tax relief?
It is important to note that there is a limit to the amount an individual can save into their pensions on an annual basis. This is known as the pensions annual allowance.
Currently, the allowance is £40,000. This means that if a person were to save more that £40,000 into a pension pot over the course of a year, it would be subject to income tax at the highest rate of income the individual in question pays, rather than receiving tax relief.
Although, it should be noted that it is possible to carry forward unused allowances for the previous three years, provided that the saver was a member of a pension scheme for the duration.
Pension tax relief is a great motivational tool to prompt individuals to save for their retirement. However, it is important to understand the basics so that Britons are able to save for the future in the most tax-efficient way.
Of course, expert financial advice is always available to those who are still struggling to get to grips with pension tax relief. An adviser will be able to explain exactly how it impacts their retirement finances in clear, jargon-free language. Doing so will allow adults to be rewarded for planning for their future, without worrying about being hit with an unexpected tax bill.