With various reliefs available, what is the true cost of pension contributions to individuals?
An individual under 75 years of age is entitled to tax relief on the contributions they make to a registered pension scheme during a tax year.
An individual is entitled to relief on contributions up to the total amount of their relevant UK earnings chargeable to income tax for the year. However, if the pension scheme operates tax relief at source, contributions of up to £3,600 gross will obtain tax relief even if total relevant UK earnings are less than that amount or even if they are £nil.
Tax relief at source
Most personal pension schemes operate relief at source arrangements, whereby tax relief at the basic rate is deducted from the amount of the contributions payable and the scheme administrator recovers the basic rate tax from HMRC. If the person is a higher rate taxpayer, they claim relief for the excess of the higher rate over the basic rate in their self-assessment tax return. The effect is that their basic rate limit for the year is increased by the gross amount of the contributions.
Mr A is employed and his salary for 2017/18 is £90,000. During the year he paid £16,000 in cheques to his personal pension scheme.
The amounts paid of £16,000 are called the net contributions. The gross equivalent would be £16,000 x 100/80 = £20,000.
The pension scheme administrator will recover £4,000 from HMRC and this amount will be paid into the pension scheme by HMRC.
Mr A will enter £20,000 (the gross contributions) in his self-assessment tax return form SA100 in box for ‘payments to registered pension schemes where basic rate tax relief will be claimed by your pension provider’.
Mr A’s basic rate band (which would normally be £33,500) is extended by £20,000 to £53,500 and he will pay tax on £53,500 of his taxable income at 20%.
Tax computation Pension No pension
of £20,000 gross
Salary £90,000 £90,000
Personal allowance £11,500£11,500
Taxable income £78,500 £78,500
Basic rate £53,500 @ 20% £10,700
Higher rate £25,000 @ 40% £10,000
Basic rate £33,500 @ 20% £6,700
Higher rate £45,000 @ 40% £18,000
Total tax liability £20,700£24,700
If a pension contribution of £16,000 net is paid the employee will receive £69,300 (£90,000 less tax of £20,700) less pension paid £16,000 being £53,300 ignoring National Insurance and have a pension pot of £20,000.
With no pension contribution the employee will receive £65,300 (£90,000 less £24,700) ignoring national insurance.
Employer contributions to an employee's personal pension scheme would normally be paid gross. The employer would normally obtain tax relief in computing taxable profits for the period of account in which the contributions are made. The employee is not liable to income tax in respect of the contributions by their employer to the registered pension scheme. This exemption applies to contributions to the employee’s own registered pension scheme, as opposed to contributions paid to pension schemes set up for members of the employee’s family.
Every member of a pension scheme may be liable to the Annual Allowance Charge. From 6 April 2014 the annual allowance has been £40,000. For 2013/14 it was £50,000.
A reduced annual allowance of £4,000 applies after 6 April 2015 when an individual has flexibly accessed their money purchase savings.
From 6 April 2016 for ‘high income individuals’ the amount of the annual allowance is tapered down to a minimum of £10,000. Broadly ‘high income individuals’ are those people with an ‘adjusted income over £150,000’. The annual allowance is then reduced by £1 for every £2 by which the ‘adjusted income’ exceeds £150,000 but it cannot be reduced to below £10,000. Therefore if the adjusted income is £210,000 or more the annual allowance for that year will be £10,000.
If the annual allowance is exceeded the individual will not receive tax relief on any contributions that exceed the limit and the individual will incur an annual allowance charge.
Broadly this annual allowance is compared to two figures each year. For ‘defined contribution schemes’ (DC schemes) the amount of contributions paid into the person's DC schemes in the year. For ‘defined benefit schemes’ (DB schemes) and cash balance arrangements the value of the person’s pension rights at the end of the year over the value at the beginning of the year. For this purpose, the value of an individual’s pension rights at a particular time is:
For a defined benefits scheme – the aggregate of any lump sum to which the individual would have been entitled (otherwise than by commutation of pension) if he had become entitled to payment of it at that time and 16 times the annual pension that would have been payable if the individual had become entitled to payment of it at that time
For cash balance schemes – the amount that would have been available for provision of benefits if the individual had become entitled to the benefits at that time.
Any unused part of the annual allowance for a tax year can be carried forward for up to three tax years. The current year’s annual allowance is deemed to be used first. If this is insufficient to avoid an annual allowance charge, any unused annual allowance from the three previous years can then be used with the earliest year’s unused allowance is used first and so on. This carry forward is automatic and does not need to be claimed.
Calculation of annual allowance charge
The annual increase in an individual’s rights under all registered pension schemes for which he/she is a member is compared with the annual allowance and any excess over the annual allowance is chargeable to tax. This excess is charged at:
the basic rate of tax in relation to the amount of the excess when added to the individual’s taxable income, that does not exceed the basic rate limit
the higher rate of tax in relation to so much of the excess as, when so added, exceeds the basic rate limit but does not exceed the higher rate limit
the additional rate of tax in relation to so much of the excess as, when so added, exceeds the higher rate limit.